TYBA-SEM-VI-Economics-Paper-XIV-International-Economics-English-Version-munotes

Page 1

1 MODULE I
1
INTERNAL AND INTERNATIONAL
TRADE
Unit Structure
1.0 Objectives
1.1 Meaning of International Trade
1.2 Scope of International Trade
1.3 Importance of International Trade
1.4 Difference between Internal and International Trade
1.5 Summar y
1.6 Questions
1.0 OBJECTIVES International economics plays a very important role in the world economy.
International economics helps in economic, social and political
development of the country. In this lesson of International Economics, we
are going to study in terms of international trade. The objectives of this
lesson are as follows:
• To study the concept and importance of international economics.
• To study the difference between interregional or internal and
international trade.
• To study th e scope of international trade.
1.1 MEANING OF INTERNATIONAL TRADE International trade means trade between the two or more countries.
International trade involves different currencies of different countries and
is regulated by laws, rules and regulations of the concerned countries.
Thus, International trade is more complex.
According to Wasserman and Haltman, “International trade consists of
transaction between residents of different countries”.
According to Anatol Marad, “International trade is a trade be tween
nations”.
According to Eugeworth, “International trade means trade between
nations”.
International trade is in principle not different from domestic trade as the
motivation and the behaviour of parties involved in a trade do not change munotes.in

Page 2

2 International Economics
2 fundamentally regardless of whether trade is across a border or not. The
main difference is that international trade is typically more costly than
domestic trade.
1.2 SCOPE OF INTERNATIONAL TRADE 1. Export and Import of Goods:
International trade involves the import an d export of goods. It is also
called invisible trade.
2. Export and Import of Services:
This is also known as invisible trade. Invisible trade includes tourism,
transportation, telecommunications, banking, warehousing, distribution,
and advertising.
3. Lic enses and Franchises:
A license is a contractual arrangement whereby one company (the
licensee) grants access to its patent, copyright, trademark or technology to
another foreign company (the licensee) at a rate called a royalty. Pepsi and
Coca -Cola are pr oduced and sold worldwide under a license system. A
franchise is similar to a license, but a term used in the context of the
provision of services. For example, McDonald's operates fast -food
restaurants worldwide through its franchise system.
4. Foreign In vestment:
It involves investing funds abroad in return for financial gains. There are
two types of foreign investment.
(A) Foreign Direct Investment (FDI) :
Investing in foreign assets such as plant and machinery for the purpose of
manufacturing and marketi ng goods and services abroad.
(b) Portfolio Investments -
Liability to invest in shares of a foreign company or to earn income by
way of dividends or interest.
1.3 IMPORTANCE OF INTERNATIONAL TRADE International trade has become very important in modern eco nomy. Even a
country like England has achieved its development through international
trade. It is clear that international trade is the foundation of modern
economic development. An important reason for the industrial progress
made by the advanced countrie s like America, France, Germany, Japan
etc. can be found in the trade policy adopted by them. Therefore, classical
economists consider international trade as an engine of economic
development and not merely a means of increasing production. munotes.in

Page 3

3 Internal And International Trade The importance of the study of International Trade can be explained as
follows.
1) The o ptimal use of the natural resources of a country :
The international trade between two or more nations helps all of them to
make the best possible use of their natural resources. Ever y country can
focus on the production of goods and services using these resources and
sell them to other nations to earn foreign exchange and shore up their
economy. It also helps to avoid the wastage of crucial resources and use
them to improve the overal l economic standing of the country.
2) The a vailability of different types of goods and services :
One of the major benefits of international trade is that it enables a country
to obtain goods and services that it is unable to make on their own due to
lack of resources or higher costs of production. They can get these goods
from outside the country at relatively lower costs.
3) The s pecialisation in the production of certain goods and services :
Some nations are endowed with certain advantages like natural resources,
workforce, technology and capital. These resources allow them to engage
in the production of certain kinds of goods and services at relatively
cheaper costs and sell it to other nations who need them. They can engage
in large scale production to cater to the needs of home domestic as
consumption as well as serve the international markets. They can also
dispose of goods and services which they possess in large quantities to
other countries and improve their foreign exchange reserves in return.
4) The s tability in prices of products and services :
It is one of the major benefits of international trade. It helps to iron out the
benefits and put a stop to the wild fluctuations that can arise due to the
non-availability of these products.
5) The e xchan ge of technical expertise :
International Trade allows countries with a lack of knowledge in terms of
production, manufacturing and technology to access it from other nations.
Underdeveloped countries can take the help of the developed ones to
establish an d develop industries apart from increasing their economic
prosperity.
6) Improve efficiencies in terms of production and distribution of
goods and services :
Countries can take advantage of international trade to increase their scale
of production and make it more efficient to cater to the demands of other
nations. They can also focus on producing better quality products and
services while minimising the overall costs.
munotes.in

Page 4

4 International Economics
4 7) The d evelopment of transport and communication :
International trade between nations can flourish only if the means of
transport and communications are robust and highly efficient. Or else, it
will lead to bottlenecks that can hamper the viability of the transactions.
International trade often acts as an incentive for nations to improve th eir
transportation and communication with other countries to facilitate the
continuous exchange of goods and services.
8) Improved relations :
International trade between nations also leads to a greater scope of
communication between the two nations. It en ables the exchange of
knowledge and ideas as well. This can foster greater cooperation and
understanding and act as a cornerstone for developing more cordial
relations between the two countries.
Conclusion :
The benefits of International Trade far outweigh the risks, and it also leads
to greater economic prosperity for the economies involved. The size of the
world economy has jumped manifold in the past decade, and it is a result
of the increased volume and value of the exchange of goods and services
between nations.
1.4 DIFFERENCE BETWEEN INTERNAL AND INTERNATIONAL TRADE Trade means exchange of goods. What difference, then, does it make to
the theory of trade whether these goods are made in the same country or in
different countries?
Why is a separate theory of international trade needed? Well, domestic
and foreign trade are really one and the same.
They both imply exchange of goods between persons. They both aim at
achieving increased production through division of labour.
There are, however, a number of thi ngs which make a difference between
foreign trade and domestic trade and necessitate a separate theory of
interna-tional trade.
(i) Immobility of Factors of Production:
Labour and capital do not move freely from one country to another as they
do within the same country. “Man”, declared Adam Smith, “is, of all
forms of luggage, the most difficult to transport”. Much more so when a
foreign frontier has to be crossed. Hence differences in the cost of
production cannot be removed by moving men and money, the re sult is the
movement of goods.
On the contrary, between regions within the same political boundaries,
people distribute themselves more or less according to opportunities. Real munotes.in

Page 5

5 Internal And International Trade wages and standard of living tend to seek a common level, though they are
not w holly uniform. As between nations, however, these differences
continue to persist for wages and check population movements. Capital
also does not move freely from - one country to another. Capital is
notoriously shy.
(ii) Different Currencies:
Every country has a different currency. India has the rupee and the U.S.A.
has the dollar, Germany the mark, Italy the lira, Spain the peso, Japan the
yen, and so on. Hence, buying and selling between nations give rise to
complications absent in internal trade.
(iii) Restrictions on Trade:
The trade between different countries is not free. Very often there are
restrictions imposed by custom duties, exchange restric-tions, fixed quotas
or other tariff barriers. For example, our country has imposed heavy duties
on import of motor cars, wines and liquors and other luxury goods.
(iv) Ignorance:
The k nowledge of other countries cannot be as exact and full as of one’s
own country. Differences in culture, language and religion stand in the
way of free communication between dif ferent countries. On the other
hand, within the borders of a country, labour and capital freely move
about. These factors, too, make internal trade different from international
trade.
(v) Transport and Insurance Costs:
Then costs of transport and insurance also check - free international trade.
The greater the distance between the two countries, the greater are these
costs. Wars increase them still more.
Thus, comparative immobility of labour and capital, restric-tions on trade,
transport and other costs, ig norance, and differences in language, customs,
laws and currency systems make international trade different from
domestic trade and necessitate a separate theory of international trade.
1.5 SUMMARY In this chapter the meaning of international trade and va rious definitions
of international trade are given. Also, the scope of international trade is
elaborated and the importance of international trade and international
economics is also highlighted. We have also studied the meaning of
interregional and intern ational trade and the difference between these two
trades. This shows that international trade is necessary and beneficial for
every nation. munotes.in

Page 6

6 International Economics
6 1.6 QUESTIONS Q.1 What is international economics? Explain the importance of
international economics?
Q.2 What ar e the salient features of international trade?
Q.3 Explain the difference between international trade and international
trade?
Q.4 Explain the characteristics of international economics.
*****
munotes.in

Page 7

7 2
THEORIES OF INTERNATIONAL TRADE
Unit Structure
2.0 Objectives
2.1 Introduction to Theories of International Trade
2.2 Adam Smith’s Theory of International Trade
2.3 Ricardian Theory of Comparative Cost Difference
2.4 Heckscher -Ohlin Theory
2.5 Leontief’s Paradox
2.6 Krugman’s Model
2.7 Summary
2.8 Questions
2.9 References
2.0 OBJECTIVES • To understand Adam Smith's theory of international trade and its
importance.
• To study Ricardo's theory of comparative cost advantage.
• To underst and Heckscher -Ohlin theory.
• Studying Leontief's Paradox and Krugman's model.
2.1 INTRODUCTION TO THEORIES OF INTERNATIONAL TRADE Trade whether internal or external or international and economic
development are closely related to each other. There is a c omplementary
relationship between trade and economic development. Trade leads to
increase in the volume of trade. The increase in the volume of trade
facilities economic development of the participating countries. The
economic development in its own term f acilities trade. Trade comes into
being when countries produce surplus goods over and above their
domestic demand or requirement. When surpluses are exchanged against
surpluses trade comes into being. When trade remains within the
geographical or political boundary of the country it is called as domestic
trade and when trade or exchange crosses the geographical or political
boundary of the county it gets referred to as international or global trade.
As per the comparative costs theory of international trade propounded by
David Ricardo international trade benefits all the trading partners which
can be referred to as gains from international trade. The gains from
international trade spring up to the trading partners due to division of
labour i.e. specializatio n, reallocation of factors of production, optimum munotes.in

Page 8

8 International Economics
8 expectation of resources, saving of the cost of production etc. Instead of
producing all the goods domestically it is better to produce only those
goods in which it has got comparative superiority. If it do es so it can
produce the goods more cheaply. If all the trading countries follow the
same tactics them the people of these trading countries enjoy consumer's
surplus as they get the goods from foreign countries at a low price as
compare to domestic price. All these things are illustrated with help of
international trade theories.
Theories of International trade:
There are two very important theories of international trade viz.
1) Classical Theory of International Trade.
2) Modern Theory of International Trade
There are two versions to the classical theory of International Trade viz.
i) The Theory of Absolute Cost Differences.
ii) The Theory of Comparative Cost Differences.
2.2 ADAM SMITH’S THEORY OF INTERNATIONAL TRADE The Theory of absolute cost adva ntages was propounded by Adam Smith.
It was he who advocated free trade i.e. laissez faire par excellence. It was
a reaction against mercantilism. The mercantilist propounded the theory of
protection i.e. one way trade only. The gospel of the theory of pro tection
i.e. one way trade of the mercantilists was, “Only export, Don't import".
This gospel was meant for strengthening of the national economy. As a
reaction. against mercantilism Adam Smith advocated free trade. As per
the principle of free trade there should be no obstacles between the
exchange of goods from one country to another. It benefits all the trading
countries. The country doesn't make any difference between the domestic
goods and the foreign goods. Adam Smith was the champion of division
of labour i.e. specialization. Instead of producing all the goods the country
should specialize in the commodity in which it has absolute cost
advantage. The international division of labour leads to reallocation of
resources which leads to increase in the vol ume of trade. Each country
specialises in the production of a commodity in which it is best suited
which leads to enrichment of both the trading countries.
Illustration:
The above stated points can be illustrate with the help of a numerical
hypothetical ex ample.
Adam Smith presented a two countries, two commodities and one factor
model of international trade.
munotes.in

Page 9

9 Theories Of International Trade Commodities Country A Country B 1) Wheat 25 tonnes 15 tonnes 2) Cloth 15 metres 25 metres
The table highlights the following points:
1) Ther e are two countries viz. country A and country B participating in
the international trade.
2) There are two commodities taking part in the international trade viz.
wheat and cloth.
3) Assumption of labour theory of value. According to labour theory of
value labour is homogenous. The cost of production is expressed in
terms of labour cost.
4) With the help of one unit of labour country A produces 25 tonnes of
wheat and 15 metres of cloth domestically while country B produces
15 tonnes of wheat and 25 metr es of cloth.
5) The comparison of domestic production figures show that country A
has got an absolute superiority over country B in the production of
wheat because it produces 25 tonnes of wheat while country B
produces 15 tonnes of wheat with the help of given unit of labour.
Conversely country B has got an absolute superiority over country A
in the production of cloth because country B produces 25 metres of
cloth while country A produces 15 metres of cloth with the help of a
given unit of labour.
6) Under this scenario country A will be called upon to specialise in the
production of wheat while country B will be called upon to specialise
in the production of cloth.
7) The specialization or division of labour will bring about reallocation
of factors of production such that country A will withdraw factors of
production i.e. labour from the production of cloth and will employ on
the production of wheat. Conversely country B will withdraw factors
of production i.e. labour from the production of wheat which will be
employed in the production of cloth.
8) The reallocation of resources will lead to double the production. Now
country A will produce 50 tonnes of wheat while county B will be is a
position to produce 50 metres of cloths. In this way surpluses will be
created which will lead to exchange of surpluses leading to an
emergence of international trade.
9) It leads to increase in the total volume of trade. Before international
trade the total volume of trade was of the order of 40+40= 80 units.
After inte rnational trade the total volume of trade will be of the order
of 50+ 50 = 100 units i.e. there is an excess of 20 units over 80 units. munotes.in

Page 10

10 International Economics
10 However it is found that the absolute cost advantage theory is highly
unrealistic, hypothetical and narrow is scope. Pro f. Higgins divided the
world in to categories viz. the DCs and the LDCs i.e. the Developed
countries and the less developed countries on the basis of per capita
income. The per capita income of the DCs is very high as compared to the
LDCs. The DC's can exp erience an absolute superiority while the LDCs
can't. Thereby Adam Smith has narrowed down the scope of his theory
which encompasses only DC's in its fold and the LDCs are relegated to the
background. The LDCs partly produce the goods and partly import for m
the DCs.
The drawbacks of the absolute cost difference theory leads us to study
another classical theory of international trade namely comparative costs
theory of international trade propounded by David Ricardo.
2.3 RICARDIAN THEORY OF COMPARATIVE COST DIFFERENCE The comparative costs theory of international trade was propounded by
David Ricardo in his book." Principles of political Economy" which was
published in the year 1817. His international trade theory was based upon
his labour theory of value. Acc ording to this theory the value of the
commodity is determined by its labour cost. The goods are exchanged on
the basis of the relative amount of labour embodied in them. As per the
labour value theory there is a tendency of wages equalling to the prices o f
goods.
Ricardo's labour theory of value assumes the following things:
1) `Labour is the only productive factor of production
2) `Total cost means labour cost.
3) `Labour is homogenous.
4) `There is a perfect mobility of labour.
5) `Perfectly competitive labour market.
Assumptions of his comparative cost theory of international trade:
1) Two countries, two commodities and one factor model of
international trade.
2) Cost of production is the labour cost because labour is the only
productive factor of prod uction.
3) Prices of goods are determined on the basis of labour cost embodied
in them.
4) Perfect competition.
5) Perfect mobility of labour domestically but immobility of labour
internationally. munotes.in

Page 11

11 Theories Of International Trade 6) Constant returns to scale.
7) Existence of full emp loyment.
8) Free trade
9) Division of labour i.e. specialization.
10) No transport cost.
To illustrate the comparative costs theory of international trade let us take
a numerical hypothetical model of international trade as was taken by
David Ricardo hi mself in his book "The principles of political Economy"
published in the year 1817.
The basis of international trade is the comparative cost difference.
Different countries specialise in the production of goods on the basis of
comparative costs advantage. All the world counties are not endowed with
similar natural bounties i.e. nature makes a difference between countries
as regards natural bounties. Therefore different countries of the globe are
called upon to specialise in the commodities in which they hav e got a
comparative cost advantage such that these countries can produce the
goods comparatively at a cheaper rate. If all the world countries follow
this they stand to benefit thereby in terms of division of labour i.e.
specialization reallocation and opt imum exploitation of resources, savings
of the cost of production etc. Countries Commodities Domestic Exchange Rate Wine Cloth 1) Portugal 80 90 1W : 0.89 C 2) England 120 100 1W : 1.2 C Cost Ratios 0.67 0.90
The above table tells us that Po rtugal produces one unit of wine with the
help of 80 hours of labour and one unit of cloth with 90 hours of labour.
While England produces one unit of wine with 120 hours of labor and one
unit of cloth with the help of 100 hours of labour. From this scenar io it is
clear that Portugal has got absolute superiority over England in the matter
of production of both the commodities viz. wine and cloth become it can
produce both wine and cloth at an absolutely lower cost as compare to
England. Conversely England h as got an absolute disadvantage in the
matter of production of both the commodities viz, wine and cloth as the
cost of Production of both the commodities is very high as compare to the
cost of production of both wine and cloth in Portugal.
Under this scena rio if we would like to know the comparative cost
advantage we will have to compare the ratios of cost of production of both
the commodities in both the countries (i.e. wine in both the countries and munotes.in

Page 12

12 International Economics
12 cloth in both the countries). The table shows that the c ost ratio of wine in
Portugal comes to 80/120 = 0.67
While the cost ratio of cloth in Portugal comes to 90/100 = 0.90 If we
compare these two ratios we find that 0.67 is less than 0.90. It tells us that
though Portugal has got absolute superity or absolute cost advantage over
England in both the commodities viz. wine and cloth its superiority is
greater in wine than in cloth. It means that Portugal has got comparative
cot advantage in the production of wine. Conversely take the case of
England. England has got absolute cost disadvantage over Portugal in the
production of both the commodities viz. wine and cloth because it
produces both the commodity at an extremely higher cost as compare to
cost of production of wine and cloth in Portugal. However the
disadv antage of England is comparatively less in cloth than in wine.
120/80 = 1.5; 100/90 = 1.1
1.1 < 1.5
In a situation of this type Portugal will be called upon to specialise in wine
manufacture. It will undertake reallocation of resources i.e. it will
withdr aw labour from cloth manufacture and will employ it in wine
manufacture to create surpluses. Conversely England will be called upon
to specialise in cloth manufacture. It will bring about reallocation of
resources by withdrawing labour from wine manufactur e and will employ
it in cloth manufacture to create surplus. International trade will come into
existence by exchanging surpluses i.e. Portugal will export wine to
England and will import cloth from England. Conversely England will
export cloth to Portugal and will import wine from Portugal.
Any exchange ratio between 0.89 and 1.2 will benefit both the countries
viz. Portugal and England. It is advantageous to Portugal to export wine to
England where 1 unit of wine commands 1.2 units of cloth such that be
exporting wine to England she gets more than 0.89 units of cloth i.e. 1.2
units of cloth from England against 1 units of wine. It is advantageous to
England to export cloth to Portugal where 1 unit of wine is exchanged at
0.89 units of cloth. It means for o ne unit of wine it has to give less than 1.2
units of cloth (i.e. 0.89 units of cloth) If 1:1 exchange rate gets established
when the international trace takes pace Portugal gains because she gets 1
unit of cloth against 80 hours of labour. In the absence of international
trade it would have got it for 90 hours. Thus it saves 10 hours of labour. It
also implies that Portugal gets 0.11 units of extra cloth from England.
Conversely England also benefits from international trade. It gets 1 unit of
wine for 100 hours of labour which would have cost for 120 hours of
labours in the absence of international trade. It means that England saves
20 hours of labour. It also implies that England gets 0.17 units of wine
more.
Critical Evaluation:
i) David Ricardo has ass umed full employment. But full employment is
a myth. It is an ideal goal which all the world countries cherish. But munotes.in

Page 13

13 Theories Of International Trade this goal is hardly realised specially by the underdeveloped countries.
The underdeveloped countries suffer from unemployment,
underemployme nt and disguised unemployment.
ii) He has assumed free trade i.e. laissez faire. Free trade or laissez faire
entails cut throat competition. In underdeveloped countries there is a
vast ocean of infant industries which can't survive under conditions of
free trade i.e. they can't stand on their own legs. These infant
industries need protection. Thus the assumption of free trade instead
of spreading mutual gain will lead to making the poor country poorer.
iii) Secondly the underdeveloped countries are primari ly primary
producing countries. These countries rely on the export of food stuffs
and raw materials for which the foreign demand is elastic while they
rely heavily on import of machinery, technology, spare parts etc for
which their demand is inelastic. In a situation of this type international
gain will spring upto the DC's while the LDC's will sustain losses.
iv) He has assumed fixity of the factors of production which therefore
involve reallocation of factors of production. The developing
economics are u nder taking planned economic development wherein
resource go on fluctuating. Planning entails more resources.
When there is a dearth or pancity of resources how can there be
reallocation of resources. As a matter of fact the LDC's have to
generate more res ources.
v) He has assumed constant returns to scale. As a matter of fact in the
actual life there can be either increasing returns to scale or decreasing
returns to scale. Most of the underdeveloped countries are agricultural
countries and the DC's are in dustrially advanced countries. The DC's
experience increasing returns to scale while the LDC's experience
decreasing returns to scale.
vi) David Ricardo has assumed a perfect mobility of labour domestically
and immobility of labour internationally. Perfec t competition is also a
myth. Underdeveloped countries suffer form market imperfections,
ignorance, personal attachment, transport bottlenecks, production
bottlenecks, power failures, strikes personal likes and dislikes due to
which domestic mobility gets hampered.
vii) The LDC's constantly suffer from disequilibrium in their balance of
payments hence they have to switchover to tariffs, import quotas
import licensing etc.
2.4 HECKSCHER -OHLIN THEORY The modern theory of international trade was propounded by Swedish
economist Bertil Ohlin is his book "Inter - regional and international trade
published in 1933. The modern theory of international trade is also known
by various names which are as follows: munotes.in

Page 14

14 International Economics
14 1) It is known as "General Equilibrium Theory of internat ional trade". It
is because general equilibrium rules are applied in case of
international trade. When in the market twin market forces viz. total
demand and total supply are in equilibrium the equilibrium price gets
established in the market.
ii) It is a lso known as "Factor proportions Theory" It is because different
countries are endowed with different factors of production. Some
countries have a Surplus of some factors and scarcity of some factors.
For example if there are two countries viz. Australia a nd England.
Australia has got land in abundance than capital. Conversely England
has got an abundance of capital over land. In a situation of this type
Australia will specialize in the production of wool which will call for
the employment more land and les s capital conversely England will
specialize in the production of machinery which will call for an
employment of more capital and less land which gets referred to a
factor proportion.
iii) It is also called as "Heckschar Ohlin theorem". It is because befo re
ohlin it was Heckscher who enunciated the mutual interdependence
theory of international trade. Lateron it was Bertil Ohlin who
developed, refined and renovated the mutual interdependence theory
of international trade. It is become of joint endeavour of two viz.
Heckscher and ohlin that led to an emergence of international trade
theory hence the modern theory of international trade gets referred to
as "Heckscher Ohlin theorem.
iv) The modern theory of international trade is also called as "mutual
interd ependence theory". It is because the sole basis of the emergence
of international trade is the difference is the price of the final goods.
There is a mutual interdependence between the price of the final
goods and the price of the factors of production PG = f (DG and SG)
PG stands for price of goods.
F stands for functional relationship.
DG stands for demand for goods.
SG stands for supply of goods.
i.e. the price of a commodity depends upon the demand for and supply of a
commodity.
PG= f (PF)
i.e. The pric e of a commodity i.e. goods depends upon factor price.
PF = f(DF and PF)
i.e. Factor price depends upon the demand for and supply of factors of
production. munotes.in

Page 15

15 Theories Of International Trade v) It is also known as monetary theory of international trade. It is
because of an application of a foreign exchange rate to the
phenomenon of international trade.
Bertil Ohlin says "International trade is nothing but a special case of inter -
regional trade". It is because of which the single market theory get applied
to multi market trade.
As a matter of fact instead of criticizing the comparative cost theory of
David Ricardo,
Bertil Ohlin supports his theory and says the following:
i) "The comparative cost theory is applicable to all trades whether
internal i.e. inter -regional or international. As a matter of fact David
Ricardo had limited the scope of his comparative cost theory by
applying it only to international trade".
ii) "The immobility of labour is not an exclusive feature of intentional
trade. It is also applicable in interregional trade i.e . domestically also
labour is immobile because of regionality, likes an dislikes, taste and
preferences, etc. Therefore we find that wages and interest rates are
different in different provinces of India. Therefore Bertil Ohlin said,
"The immobility of fac tors of production is a matter of degree and not
of kind". Hence he said "There is no need for a separate theory of
international trade. International trade is a special case of inter -
regional trade".
He picks up a double model system i.e.. two countries, two commodities
and two factors model to illustrate the above points which is as follows: -
The two countries are Australia and England. The two commodities are
wool and machinery and the factors are land and capital. In Austria there
is an abundance or sur plus of land in relation to capital which is scarce
while in England capital is in abundance while there is a scarcity of land.
In a situation of this type Australia specializes in the production of wool
which needs more land and less capital while England specializes in the
manufacture of machinery which requires more capital and less land.
Australia produce wool cheaply i.e. at an extremely low cost of production
because of which the price of wool will be extremely low in Australia.
Conversely England pro duce machinery at an extremely low cost of
production because of which the price of machinery will be extremely low
in England. In a situation of this type Australia exports wool to England
and imports machinery from England. England exports machinery to
Australia and imports wool from Australia. Bertil Ohlin has indirectly
made the land mobile from Australia to England just like a playback
singing. (The singer is at the back of an actor/actress who money the ups.)
When Australia exports wool to England ind irectly it has exported land to
England.
It is already pointed out that Berlil Ohlin’s theory is also called as
monetary theory of international trade because of an application of an munotes.in

Page 16

16 International Economics
16 element of foreign exchange rate in the realm of international trade. The
application of foreign exchange rate transforms comparative costs into
absolute cost. But the very important point to be remembered is that
foreign exchange rate is not the basis of international trade.
There are two countries viz. India and USA both the countries have got
different monetary units. India has got rupee while USA has got dollar as
their currencies. Suppose of the foreign exchange rate between dollar and
rupee is 1 $ = Rs. 40. Commodities India (Rs.) U.S.A ($) Conversion of dollar into rs. A 10 0.5 20 B 20 1.0 40 C 70 1.5 60 D 90 2.0 80 Before conversion of American dollar into Indian rupees we can't make
out as to what is what? When we convert dollar into rupees the picture
becomes clear. From the above table it is clear that commoditi es A and B
are cheaper in India while commodities C and D are cheaper in U.S.A. in a
situation of this type India will be called upon to specialize in the
production of commodities. A and B and export A and B to USA while
USA will be called upon to special ize in commodities C and D and export
these two commodities to India.
2.5 LEOTIEF’S PARADOX One of the attractions of the HO theory is that it provides us with set of
fairly simple and readily testable predictions. One of the first attempts
made to test th e theory was made by a Russian -born economist, Wassily
Leontieff (b.1906) in 1954. Using the 1947 input -output tables for the
United States, he sought to test the proposi tion that the US had a
comparative advantage in capital -intensive goods and therefore traded
these goods for imported labour -intensive products. Leontieff measured
the factor inten sity of U.S. exports and import replacements using the
input -output tables. The reason for taking import replacements (U.S.
produced goods that are substitutes for goods imported) rather than
imports was that information about factor intensities could not be obtained
for all the products which the US imported or for all the countries from
whom she imported. If the factor intensities for these products are the
same in other countries, the use of import replacements need pose no
major problems. Interestingly, Leontieff's results showed that U.S. imports
were more capital -intensive than U.S. exports, the exact opposite of what
the theory predicted (Leontieff, 1954)! munotes.in

Page 17

17 Theories Of International Trade The Leontieff Paradox, as it came to be known, seemed to prove that the
HO theory was wrong. Subsequently, a variety of explanations were put
forward for Leontieff's results.
1. One possible explanation was that the year chosen. 1947, was not
very representat ive given that trading patterns may still have been -
distorted by the ending of the Secon d World War. However, attempts
to carry out the same test for later years reproduced the same result
and thus appear to refute the explanation (Leontieff, 1956).
2. A second explanation focused on the use of import replacements
rather than imports. If products imported by the US were produced by
different methods in other countries to those adopted in the US, factor
intensities will differ and the use of import replaceme nts as a proxy
for imports will render the, theory invalid. Specifically, it is possible,
given the scarcity of labour in the US, that goods that are produced by
labour -intensive methods abroad, are produced by capital intensive
methods in the US. This is known as factor -intensity reversal
(Ellsworth, 1954) The important question is: to what extent does
factor -intensity reversal occur in reality) and is it of sufficient
importance to render the HO theory invalid? If factor -intensity
reversal is a common occ urrence then the HO assumption that all
countries face identical production functions for the same good is not
valid and the theory breaks down. Empirical research his established
that factor -intensity reversal does, indeed, take place (Minhas 1963).
Howev er, it appears that, in most cases, it is not sufficient to account
for the result obtained by Leontieff. (See Leontieff 1964, Moroaey,
1967, Bhagwati, 1969.)
3. A third explanation is that the assumption of identical consumer
preferences is invalid. Specific ally, it was argued that, in 1947, on
account of their higher per capita income; U.S. consumers had a
greater preference for capital -intensive goods. Higher quality
consumer goods are generally more capital -intensive than lower
quality ones (see Houthakk er, 1957).
4. The explanation preferred by Leontieff was that U.S. labour Was
superior to that of other countries. Quite arbitrarily, he gave a figure
of three to one as the difference between the efficiency of U.S. labour
and that of - other countries. In tha t case, labour could not be
described as relatively scarce and the fact that U.S. exports were more
labour -intensive than U.S. imports was hardly surprising. The main
problem with this argument is that it is by no means apparent why this
hold be true of labor alone. There is every reason to suppose that U.S.
capital was also more productive than that of other countries, in which
case the capital -labour ratio would be unaffected and the presumption
that labour was relatively scarce would still hold. No em pirical
evidence has been forthcoming to contradict this.
5. A further explanation has emphasised the failure of Leontieff to
distinguish human from physical capital. Human capital finds its munotes.in

Page 18

18 International Economics
18 embodiment in the skills and education of a country's labour force . If
allowance is made for this, it would be the case that U.S. exports are
more capital -intensive than Leontieff found. In a later work, Leontieff
himself found that the average level of skill of the labour force in the
U.S. was higher in the export than the import replacements sector
(Leontieff, 1956). Subsequently, Kenen (1965) has shown that, once
human capital is included, the Leontieff Paradox is reversed but only
just. On the other hand, using a different method of estimating human
capital, Baldwin ( 1971) found that, while the inclusion of human
capital was sufficient to weaken the Paradox, it was' not enough to
reverse it. In fact, since physical and human capital are hardly
perfectly substitutes, it is more appropriate to treat human capital as a
separate factor of produc tion. Since human capital and not capital in
aggregate is most probably the United States' most abundant factor of
production, the right test to perform is to measure the relative human
capital intensity of U.S. exports.
6. The next ex planation concerns natural resources that are moitted as a
factor from the model used by Leontieff. The HO model becomes
more complex if a third factor of production is introduced. Attention
was drawn to the fact that, on account of her rapid industrialisa tion,
the US had become rela tively deficient in natural resources such that
much of what she imported consisted of resource -intensive goods.
The possibility, therefore, existed that natural resources and not
labour were her relatively most scarce factor. Therefore, the US had
become an exporter of both capital - and labour -intensive goods in
exchange for resource -intensive goods. In a later study, Leontieff
excluded certain resource imports which were non competitive with
U.S. production (i.e. they could no t be produced anywhere in the US)
and found that the original Paradox disap peared. Work by Vanek
(1963) confirmed that U.S. imports were more resource -intensive than
her exports. He also found some evidence that capital and natural
resources were compleme ntary in U.S. imports but not in U.S.
exports. If so, this would impart a capital -intensive bias to U.S.
imports.
2.6 SUMMARY  The main purpose of this chapter is to point out the basis of
international trade.
 International trade and economic development a re complementary to
each other.
 There are two main theories of international trade viz.
a) Classical theory of international trade.
i) There are two version to the classical theory of international trade
viz.
i) The Absolute cost difference theo ry of Adam Smith. munotes.in

Page 19

19 Theories Of International Trade ii) The comparative cost difference theory of David Rilcardo
b) The modern theory of intentional trade of Bertil Ohlin.
 The Absolute cost difference theory limits the scope of international
trade.
 The comparative cost advantage theory widens the scope of
international trade by involving DCs and LDCs in to the realm of
international trade.
 The modern theory of international trade supplements the comparative
costs theory of international trade.
 The modern theory of international t rade is a monetary theory of
international trade because of an application of an element of foreign
exchange rate in the relm of international trade.
 The foreign exchange rate doesn't facilitate the international trade but
merely transforms the comparative advantage into absolute advantage
i.e. it is merely an indicator of the cheapness and costliness of the
commodities.
2.7 QUESTIONS 1) Explain absolute advantage theory of International Trade.
2) Explain Ricardo's theory of comparative cost variance.
3) Explain Heckscher -Ohlin theory.
4) Explain the Leontief paradox.
2.8 REFERENCES  The Economics of development and planning by M. L. Jhingan.
 International Economics by P. Kindleberger.
 International Economics by B. O. Soderstern
 International Economics by D. M. Mithani

*****



munotes.in

Page 20

20 MODULE II
3
TERMS OF TRADE
Unit Structure
3.0 Objectives
3.1 Introduction
3.2 Concepts of Terms of Trade
3.2.1 Net Barter
3.2.2 Gross Barter
3.2.3 Income Terms of Trade
3.3 Summary
3.4 Questions
3.0 OBJECTIVES  To know the concepts of terms of t rade.
 To understand the various types of terms of trade.
 To study the limitations of terms of trade.
3.1 INTRODUCTION The study of terms of trade began with classical trade theory to measure
the benefits of international trade. The concept of terms of trade is very
important in trade theory. On the basis of terms of trade, the favorability
(advantage) or disadvantage of two countries in international trade is
calculated. In Ricardo's analysis, the comparative advantage theory of
international trade stat es that the comparative advantage of production
expenditure in the domestic economy is the main factor that determines
the advantage of international trade. But Ricardo did not analyse how the
benefits of international trade would accrue to which country o r how they
would be distributed. The lacunae in Ricardo's theory were later covere d
by John Stuart Mill. Through his theory of reciprocal demand, he showed
how international terms of trade depend on the elasticity of demand of
consumers in one country for goods in another country. Thus, J . S. Mill
showed that the demand side, completely ignored by Ricardo, is an
important determinant of the international terms of trade. While doing so,
the supply side was neglected. This aspect was presented by Alfred
Marsh all in his book "Money, Credit and Commerce" written in the year
1923 with the help of offer curve technique. Alfred Marshall made the
point that the terms of trade of a country depend as much on supply as on
demand. How important is the elasticity of supp ly over the elasticity of munotes.in

Page 21

21 Terms of Trade demand in determining the terms of trade? To demonstrate this, he
developed the technique of the offer curve.
3.2 CONCEPTS OF TERMS OF TRADE Terms of trade is the rate at which one country’s goods are exchange with
another countr y’s goods. It determines the prices of the goods traded in
foreign market. It expresses relationship between export prices and import
prices of a country. When a country’s export prices are more than its
import prices, then it is favourable to the country. Since its export prices
are more than export prices it can obtain more quantity of imports. So
there is a gain for the country. A country’s terms of trade said to be
unfavourable when its export prices are less than its import prices i.e. it
can obtain a small quantity of imports with its export prices or has to pay
more import prices.
3.2.1 Net Barter Terms of Trade:
It is also called as Commodity Terms of Trade. It is used to understand the
overall view of the changes in the country’s trading in a bette r way. It is
calculated as a ratio between a country’s import and export prices i.e.as
the percentage ratio of the export unit value indexes to the import unit
value indexes, measured relative to the base year. It is mathematically
represented as,
T0 = Px / Pm
T0 → Commodity terms of trade
P → Prices and x and m → exports and imports
3.2.2 Gross Barter Terms of Trade:
Gross Barter Terms of Trade is the ratio of total physical quantity of
import to total physical quantity of export of a given country. In symbolic
terms:
TG = Qm / Qx
TG → Gross barter terms of trade
Qm → Total physical quantity of imports
Qx → Total physical quantity of exports
A higher value of TG indicate that the given country can import more
units of goods and services from abroad for the given units of exports.
3.2.3 Income Terms of Trade :
Income Terms of Trade is defined as - commodity TOT multiplied by
quantity of export. Symbolically, income terms of trade can be written as:
Ty = (Px / Pm) Qx or Px × Qx / Pm munotes.in

Page 22

22 International Economics
22 Ty → Income terms of trade
Px → Price of exports
Qx → Volume of exports
Pm → Price of imports
Income Terms of Trade can increase through an increase in export prices
i.e. when there is rise in exports, and a decrease in import prices. It is
therefore used to measure a co untry’s capacity to import.
Other Types of Terms of Trade:
Single factor Terms of Trade:
Single factor Terms of Trade is found by multiplying Net Barter Terms of
Trade with productivity index of domestic export sector. Symbolically,
Single factor Terms o f Trade can be written as:
Ts = (Px / Pm) Zx
Ts → Income terms of trade
Px → Price of exports
Pm → Price of imports
Zx → Productivity index of domestic export sector
It is the net barter terms of trade corrected for changes in the productivity
of export goods.
Double Factorial Terms of Trade:
Double Factorial Terms of Trade is calculated by multiplying Net Barter
Terms of Trade with the ratio of factor productivity of domestic industry
and foreign export industry. Symbolically, Double Factorial Terms of
Trade can be written as:
TD = TC (Zx / Zm)
TD → Double Factorial Terms of Trade
TC → Net Barter Terms of Trade / Commodity Terms of Trade
Zx → Productivity index in the domestic export sector
Zm → Import productivity index / Productivity index in the foreign
country’s export sector
It expresses the change in the productivity of both the domestic export
industry and the export industries of the foreign countries selected.
munotes.in

Page 23

23 Terms of Trade Real Cost Terms of Trade:
In case of an increase in export production drives resources are taken away
from the other sectors of the economy to the export sector. In other words,
some common resources can be used by the export sector and also the
other sectors of the economy. But since these resources are used to
increase production of export the same cannot be used in other sec tors of
the economy. Since these resources are sacrificed by the other sectors to
increase the export production, it involves some amount of disutility or
sacrifice. The amount of resources allocated elsewhere or utility cost per
unit of resources employed in the production of export goods is considered
to be the real cost terms of trade or the opportunity of exporting a good
into the exports production.
Real Cost Terms of Trade is measured by multiplying the single factor
Term of Trade by the index of the amount of disutility. It is
mathematically represented as:
Tr = Ts × Rx
Tr → Real Cost Terms of Trade
Ts → Single factor Terms of Trade
Rx → disutility or real cost in producing export goods
Utility Terms of Trade:
Utility Terms of Trade measures the changes in the disutility or
dissatisfaction of producing a unit of exports. It also measures the changes
in the satisfactions arising imports and the indigenous products wasted to
produce those exports. In other words, it calculated the changes in the Rea l
cost ToT in terms of the utilities wasted.
It is therefore calculated by multiplying the real cost terms of trade index
with an index of the relative average utility of imports and of domestic
commodities foregone. It is mathematically represented as:
Tu = Tr × U
Tu → Utility Terms of Trade
Tr → Real cost terms of trade index
U → Index of relative utility of imports and domestically foregone
commodities
Limitations of Terms of Trade :
1. Problem of Index Numbers:
All types of terms of uses index numb er to measure the variations in the
prices of goods and services in different countries at different time. Many munotes.in

Page 24

24 International Economics
24 time it becomes difficult to associate with the index numbers in terms of
its coverage, base year, and method of calculation.
2. Change in Qual ity of Product :
All types of terms of trade are based on the index numbers of export and
import prices of goods and services in participating countries. It fails to
take into consideration the changes taking place in the quality and
composition of goods e ntering trade between these countries. Generally,
terms of trade index show changes in the relative prices of goods exported
and imported in the base year. So, it fails to consider large changes in the
quality of goods that are taking place in the world, a s also new goods that
are constantly entering in international trade.
3. Problem of Selection of Period:
Terms of trade compare the changes in prices during a certain period
between the trading countries. The problem is about the selecting of this
period. In case of selected period, if it is too short then no meaningful
change may be found between the base an d the present time. If the period
is too long then there may be structural changes could have been taken
place in the trading countries and therefore export and import commodity
content could not be compared.
4. Neglect of Import Capacity of a country:
The concept of terms of trade throws neglected capacity to import of a
participating country. In case of low terms of trade in India, with a given
quantity of Indian exports a smaller quantity of imports than before is
possible. If India’s export rises, may be due to fall in the prices of exports
then it may lead to either increase of import capacity or it may remain
unchanged.
5. Not Helpful in Balance of Payment Disequilibrium:
The concept of terms of trade is applicable only if the balance of payments
of a country includes export and imports of goods and services. If the
balance of payments includes unilateral payments or unrequired exports
and or/imports, such as gifts, remittances from and to the other country
leading to disequilibrium in the balance o f payments, then the concept of
terms of trade is not helpful in measuring the gains from trade.
6. Ignores distribution of Gains from Trade between countries:
The concept of terms of trade fails to explain the distribution of gains from
trade between pa rticipating countries such as developed and developing
country. If the export price index of a developing country rises more than
its import price index, it means an improvement in its terms of trade. But
if there is an equivalent rise in profits of foreig n investments, there may
not be any gain from trade. munotes.in

Page 25

25 Terms of Trade 3.3 SUMMARY Terms of trade is the rate at which one country’s goods are exchange with
another country’s goods. It determines the prices of the goods traded in
foreign market. It expresses relationship be tween export prices and import
prices of a country.
3.4 QUESTIONS 1) Discuss the various types of terms of trade.
2) Discuss the limitations of terms of trade.

*****
munotes.in

Page 26

26 4
BALANCE OF TRADE (BOT) AND
BALANCE OF PAYMENT (BOP)
Unit Structure
4.0 Objectives
4.1 Balance of Trade (BOT)
4.2 Balance of Payments (BOP)
4.3 Difference between Balance of Trade (BOT) and Balance of
Payments (BOP)
4.4 Purchasing Power Parity The ory
4.5 Law of Reciprocal Demand
4.6 Marshall – Edgeworth Offer Curves
4.7 Gains from Trade
4.8 Case for and against Free Trade
4.9 Protection Policy
4.10 Summary
4.11 Questions
4.0 OBJECTIVES • To understand the concept of balance of t rade and ba lance of
payments .
• To st udy the difference between balance of trade (BoT) and balance
of payments (BoP).
• To study the theory of purchasing power parity.
• To understand the reciprocal demand theory.
• To understand how trade is profitable.
• To study the Marsha ll – Edgeworth offer curve.
• To study the case for or against free trade.
• To understand the protection policy.
4.1 BALANCE OF TRADE (BOT) Trade balance is also known as the balance of trade (BoT) which indicates
the distinction between the monetary value of a country’s imports and
exports in a given time period.
Balance of trade (BoT) is the visible current account of balance of
payment (BoP). munotes.in

Page 27

27 Balance of Trade (Bot) And Balance of Payment (Bop) Formula,
Trade balance calculates by below formula.
Trade Balance = Value of Exports of Goods – Value of Imports of Goods
In the case of trade balance there are two possibilities as below -
1. Positive trade balance/ Trade Surplus
2. Negative trade balance/ Trade Deficit
1) Positive trade balance/ Trade surplus:
When the value of trade balance comes positive, it means e xport value is
greater than import value, it is called as trade surplus.
Trade surplus = value of export > value of import
The positive trade balance or trade surplus has been explained in detail by
below diagram -
Figure No. 4.1 : Positive trade balance/ T rade surplus

Above diagram shows the trade surplus. In this diagram, on the X axis
imports of goods have been shown and Y axis, exports of goods. OS curve
is a trade surplus curve and OB is a trade balance curve. OS curve is a
right of OB curve which sho ws positive trade balance on which every
point (a, b & c) shows that exports of goods is greater than imports of
goods.
2) Negative Trade Balance/ Trade Deficit:
When the value of trade balance comes negative means export value is
less than import value, i t is called as trade deficit.
Trade deficit = value of export < value of import
The negative trade balance or trade deficit has been shown in detail by
below diagram. munotes.in

Page 28

28 International Economics
28 Figure No. 4.2 : Negative Trade Balance/ Trade Deficit

Above diagram indicates that the trade deficit. In this diagram, on the X
axis imports of goods have been shown and Y axis; exports of goods have
been mentioned. OD curve is a trade deficit curve and OB is a trade
balance curve. OD curve is a left of OB curve which shows negative trade
balance on which every point (a, b & c) indicates that import of goods is
greater than export of goods (export of goods is less than import of goods).
4.2 BALANCE OF PAYMENTS (BOP) 4.2.1 Meaning of Balance of Payments (BOP):
The balance of payments (BOP) o f a country is a systematic record of all
economic transactions between the residents of a country and the rest of
the world. The balance of payments is a consolidated account of the
receipts and payments from and to other countries arising out of all
econ omic transactions during the year.
In the words of C. B. Kindleberger; “The balance of payments of a
country is a systematic record of all economic transactions between the
residents of the reporting and the residents of the foreign countries during
a giv en period of time.”
The International Monetary Fund defines BOP as a “statistical statement
that subsequently summarises, for a specific time period, the economic
transactions of an economy with the rest of the world.”
4.2.2 Features of Balance of Payment Account:
(i) It is a systematic record of all economic transactions between
residents of one country and rest of the world.
(ii) It includes all transactions in goods (visible items), services (invisible)
and capital during a period of time.
(iii) It is constructed on double entry system of accounting. Thus, every
international transaction will result in credit entry and debit entry of
equal size. munotes.in

Page 29

29 Balance of Trade (Bot) And Balance of Payment (Bop) (iv) All economic transactions that are carried out with the rest of world
are either credited or debite d.
(v) In accounting sense total debit will always be equal to total credits,
i.e., balance of payments will always be in equilibrium. But in
economic sense, if receipts are larger than payments, there is surplus
in BOP. Similarly, if payments are larger than receipts, there is deficit
in BOP.
4.2.3 Structure of BOP Accounts:
According to the broad nature of the transactions concerned, the BOP of a
country is divided into four parts: (i) the current account, (ii) the capital
account, (iii) errors and omi ssions and (iv) official reserve account.
Structure of Balance of Payment : 1. Current Account a) Balance of Trade Export of Goods
Import of Goods b) Invisible Trade Export of services
Import of services c) Other Flows Investment Income
Unilatera l Transfers 2. Capital Account Long Term Capital Transaction Short Term Capital Transaction 3. Errors and Omissions 4. Official Reserve Account 1. The Current account:
The current account of BOP includes all transaction arising from trade in
goods and services, from income accruing to capital by one country and
invested in another and from unilateral transfers, both private and official.
The current account is divided in three parts:
a) The first of these is called Balance of trade or visible accou nt or
merchandise account. This account records imports and exports of
physical goods. The balance of visible exports and visible imports is
called balance of visible trade or balance of merchandise trade.
b) The second part of the account is called the i nvisibles account since it
records all exports and imports of services. The balance of these
transactions is called balance of invisible trade. It includes freights
and fares of ships and planes, insurance and banking charges, foreign
tours and education a broad, transactions out of interest and dividends
on foreigners’ investment, and so on. munotes.in

Page 30

30 International Economics
30 c) Investment income consists of interest, profit and dividends on bonus
and credits. Unilateral Transfer include grants, gifts, pension, etc.
2. The Capital account:
The capital account shows transactions relating to the international
movement of ownership of financial assets. It refers to cross -border
movements in foreign assets like shares, property, or direct acquisitions of
companies’ bank loans, governments secu rities, etc. In other words,
capital account records export and import of capital from and to foreign
countries.
The capital account is divided into two main parts one is the short term
and another is the long -term movements of capital. A short -term capit al is
one which matures in one year or less, such as bank accounts. A long -term
capital is one whose maturity period is longer than a year, such as long
term bonds or physical capital.
Long term capital account is, again of two categories: direct investme nt
and portfolio investment. Direct investment refers to expenditure on fixed
capital formation, while portfolio investment refers to the acquisition of
financial assets like bonds, shares, etc.
3. Errors and omissions:
Since BOP always balances in theory , all debits must be offset by all
credits and vice versa. In practice, rarely it happens particularly because
statistics are incomplete as well as imperfect. That is why errors and
omissions are considered so that BOP accounts are kept in balance.
4. The official reserve account:
The total of 1,2 3 and 4 comprises the overall balance. The category of
official reserve account covers the net amount of transactions by
government. This account covers purchases and sales of reserve assets
(such as gold, conver tible foreign exchange and special drawing rights) by
the central monetary authority.
4.2.4 BOP can be summarized as:
Current account balance + Capital account balance + Reserve balance =
Balance of Payments.
The equilibrium in BOP or Basic Balance:
Over all, the BOP accounts will always balance inaccounting sense. They
must balance as any flows of foreign exchange on payment sideshould
match flow of foreign exchange on receipt side. This is so because under
double entry book keeping system, the credit and debit transactions are
equal to each other.

munotes.in

Page 31

31 Balance of Trade (Bot) And Balance of Payment (Bop) Disequilibrium in BOP:
Though the balance of payment always balances in accounting sense, in
reality, the BOP will be in disequilibrium due to difference in current and
capital account. A disequilibrium in t he balance of payment means a
condition of Surplus or deficit.
A Surplus in the BOP occurs when Total Receipts exceeds Total
Payments. Thus, BOP= CREDIT>DEBIT.
A Deficit in the BOP occurs when Total Payments exceeds Total Receipts.
Thus, BOP= CREDITAutonomous and Accommodating Movement: There are two types of
transaction in Balance of payment. Autonomous and Accommodating.
Autonomous transactions are those which takes place irrespective of the
transactions in other items of the BOP. All transaction in the current and
capital accounts are autonomous transactions since they are independent
of other transaction in the BOP and are influenced by income and profit
consideration. The transaction like export and import of goods and
services, Foreign Direct I nvestment are included in this. Accommodating
transaction on the other hand are dependent on other transaction in BOP.
They are undertaken to offset the deficit or surplus in the capital or current
account. They take place when disequilibrium occurs in the autonomous
transactions. The deficit or surplus has to be balanced with the help of
accommodating flow. They are in the form of loan or foreign aid from
foreign country. They are utilized to balance the deficit or surplus in the
BOP and maintain the overa ll equilibrium of BOP.
4.2.5 Types of Disequilibrium In Balance of Payments:
Main types of disequilibrium in the balance of payments are:
i. Short -run Disequilibrium
ii. Long -run Disequilibrium
iii. Cyclical Disequilibrium
iv. Structural Disequili brium
i. Short run Disequilibrium:
It is a disequilibrium that prevails for a year or more. They occur due to a
sudden change in demand for foreign goods and services. Domestic
problems like natural calamities of financial crisis may result in increase
in imports or decline in exports. Such imbalances are temporary in nature,
and they can be corrected through short term borrowings or other
adjustments in the capital account.
ii. Long -run Disequilibrium:
The long -term disequilibrium thus refers to a deep - rooted, persistent
deficit or surplus in the balance of payments of a country. It is secular munotes.in

Page 32

32 International Economics
32 disequilibrium emerging on account of the chronologically accumulated
short -term disequilibria — deficits or surpluses. A long -term deficit in the
balance of paym ents of a country tends to deplete its foreign exchange
reserves and the country may also not be able to raise any more loans from
foreigners during such a period of persistent deficits. In short, true
disequilibrium is a long -term phenomenon. It is caused by persistent deep -
rooted dynamic changes which slowly take place in the economy over a
long period of time. It is caused by changes in dynamic factors such as
capital formation, population growth, technological advancement,
innovations, etc.
A newly deve loping economy, for instance, in its initial stages of growth
needs huge investment exceeding its savings. In view of its low capital
formation, it has also to import a large amount of its capital requirements
from foreign countries and its imports thus te nd to exceed its exports.
These become a chronic phenomenon. And in the absence of a sufficient
inflow of foreign capital in such countries, a secular deficit balance of
payments may result.
iii. Cyclical Disequilibrium:
It occurs on account of trade cycl es. Depending upon the different phases
of trade cycles like prosperity and depression, demand and other forces
vary, causing changes in the terms of trade as well as growth of trade and
accordingly a surplus or deficit will result in the balance of paymen ts.
Cyclical disequilibrium in the balance of payments may occur because:
a) Trade cycles follow different paths and patterns in different countries.
There are no identical timings and periodicity of occurrence of cycles
in different countries.
b) Incom e elasticities of demand for imports in different countries are
not identical.
C) Price elasticities of demand for imports differ in different countries.
In short, cyclical fluctuations cause disequilibrium in the balance of
payments because of cyclical changes in income, employment, output and
price variables. When prices rise during prosperity and fall during a
depression, a country which has a highly elastic demand for imports
experiences a decline in the value of imports and if it continues its export s
further, it will show a surplus in the balance of payments. Since deficit and
surplus alternatively take place during the depression and prosperity phase
of a cycle, the balance of payments equilibrium is automatically set forth
over the complete cycle.
iv. Structural Disequilibrium:
It emerges on account of structural changes occurring in domestic
economy or abroad which may alter the demand or supply relations of
exports or imports or both. Suppose the foreign demand for India’s jute
products declines because of some substitutes, then the resources munotes.in

Page 33

33 Balance of Trade (Bot) And Balance of Payment (Bop) employed by India in the production of jute goods will have to be shifted
to some other commodities of export. If this is not easily possible, India’s
exports may decline whereas with imports remaining the sa me,
disequilibrium in the balance of payments will arise. Similarly, if the
supply condition of export items is changed, i.e., supply is reduced due to
crop failure in prime commodities or shortage of raw materials or labour
strikes, etc. in the case of ma nufactured goods, then also exports may
decline to that extent and structural disequilibrium in the balance of
payments will arise. Moreover, a shift in demand occurs with the changes
in tastes, fashions, habits, income, economic progress, etc. Propensity to
import may change as a result. Demand for some imported goods may
increase, while that for certain goods may decline leading to a structural
change.
4.2.6 Causes of Disequilibrium In Balance of Payment:
Disequilibrium in the balance of payment is the r esult of imbalance
between receipts and payments in current and capital account of the BOP.
Disequilibrium in a country’s balance of payments position may arise
either for a short period or for a long period. Any disequilibrium in the
balance of payments a rises owing to a large number of causes or factors
operating simultaneously. Types of disequilibrium differ from country to
country, while the different kinds of disequilibrium and their causes in the
same country will differ at different times.
Following are the important causes for disequilibrium in the balance of
payments of a country:
1. Trade Cycles:
Cyclical fluctuations generally produce cyclical disequilibrium. Recession
or inflation in any of the developed countries can have impact on the rest
of the world. The cyclical fluctuations in income, demand, production is
transmitted from one country to another. This affects the export of the
country causing deficit in the balance of payment.
2. Huge Developmental and Investment Programmes:
Huge devel opment and investment programmes in the developing
economies are the root causes of the disequilibrium in the balance of
payments of these countries. Their propensity to import goes on increasing
for want of capital for rapid industrialisation; while expor ts may not be
boosted up to that extent as these is the primary producing countries.
Moreover, their exports of primary commodities may decline as newly
created domestic industries may require them. Thus, there will be
structural changes in the balance of payments and structural
disequilibrium will result.
3. Changing Export Demand:
Improvement in domestic production of essential food grains, raw
materials, substitute goods, etc. in advanced countries has reduced their munotes.in

Page 34

34 International Economics
34 need for import from the primary goo ds producing underdeveloped
countries. Thus, export demand has considerably changed, resulting in
structural disequilibrium in these countries.
Similarly, advanced countries also suffer from fall in exports earnings as a
result of loss of their markets in developing countries owing to the
tendency of these nations for self -reliance and their ways and means of
curtailing their imports. But disequilibrium (deficit) in balance of
payments seems to be more persistent in the underdeveloped or
developing nations than in the advanced rich nations.
4. Population Growth:
High population growth in underdeveloped countries adversely affects
their balance of payments position. It is easy to see that an increase in
population increases the needs of these countries for imports of essential
goods and decreases the capacity to export.
5. Huge External Borrowings:
Another reason for a surplus or deficit in the balance of payments arises
out of international borrowing and investment. A country may tend to
have an adverse balance of payments when it borrows heavily from
another country, while the lending country will tend to have a favourable
balance and the receiving country will have a deficit balance of payments.
6. Inflation:
Owing to rapid economic development, the r esulting income and price
effects will adversely affect the balance of payments position of a
developing country. With rising income, the marginal propensity to import
is high in these countries. This causes their demand for imported goods to
rise.
Since m arginal propensity to consume is also high in these countries,
people’s demand for domestic goods also will rise, and hence less may be
available for export. Moreover, a huge investment in heavy industries in
the developing countries may have an inflationa ry impact, as the output of
these industries will not be forthcoming immediately, whereas money
income will have been already expanded. Thus, there will be an excess of
monetary demand for goods and services in general which will push up the
price levels. A rise in the comparative price level certainly encourages
imports and discourages exports, resulting in a deficit balance of
payments.
7. Demonstration Effect:
Demonstration effect is another most important factor causing deficit in
the balance of paymen ts of a country — especially of an underdeveloped
country. When people of underdeveloped nations are influenced by
advanced countries through economicor social relations, there will be
demonstration effect on the consumption pattern of these people and the y
will desire to adopt western pattern of consumption so that their munotes.in

Page 35

35 Balance of Trade (Bot) And Balance of Payment (Bop) propensity to import increases, whereas their export earnings may remain
the same or may even decline with the increase in income, thus causing an
adverse balance of payments for the count ry.
8. Reciprocal Demands:
Since intensity of reciprocal demand for products of different countries
differs, terms of trade of a country may be set differently with different
countries under multi -trade transactions which may lead to disequilibrium
in a w ay.
9. Globalization:
In the recent years, Globalization has led to increase in movement of
goods and services and foreign investment. The competitive environment
created due to globalization has led to disequilibrium in balance of
payment of some countri es.
4.2.7 Measures to Correct Disequilibrium In Balance of Payment:
1) Expenditure reducing polices:
The important way to reduce imports and thereby reduce deficit in balance
of payments is to adopt monetary and fiscal policies that try to reduce
aggrega te demand in the economy. The fall in aggregate demand in the
economy works to reduce imports and help in solving the balance of
payments problem.
The two important instruments of reducing aggregate demand are the use
of:
(1) Tight monetary policy and
(2) Concretionary fiscal policy.
Tight Monetary Policy:
Tight monetary is used to check aggregate demand by raising the cost of
bank credit and restricting the availability of credit. For this bank rate is
raised by the Central Bank of the country which leads to higher lending
rates charged by the commercial banks. This discourages businessmen to
borrow for investment and consumers to borrow for buying durable
consumers goods. This therefore leads to the reduction in investment and
consumption expenditure . Besides, availability of credit to lend for
investment and consumption purposes is reduced by raising the cash
reserve ratio (CRR) of the banks and undertaking of open market
operations (selling Government securities in the open market) by the
Central Ba nk of the country. This also tends to lower aggregate demand
which will helps in reducing imports.
Contractionary Fiscal Policy:
Fiscal policy is also an important means of reducing aggregate demand.
An increase in direct taxes such as income tax will red uce aggregate munotes.in

Page 36

36 International Economics
36 demand. A part of reduction in expenditure may lead to decrease in
imports. Increase in indirect taxes such as excise duties and sales tax will
also cause reduction in demand. The other fiscal policy measure is to
reduce Government expenditur e, especially unproductive expenditure. The
cut in Government expenditure will not only reduce expenditure directly
but also indirectly through the operation of multiplier. It may be noted that
if tight monetary and contractionary fiscal policies succeed i n lowing
aggregate expenditure which causes reduction in prices or lowering the
rate of inflation, they will work in two ways to improve the balance of
payments. First, fall in domestic prices will induce people to buy domestic
products rather than importe d goods. Second, lower domestic prices will
stimulate exports. Fall in imports and rise in exports will help in reducing
deficit in balance of payments. However, it may be emphasized again that
the method of reducing expenditure through contractionary mone tary and
fiscal policies is not without limitations. If reduction in aggregate demand
lowers investment, this will adversely affect economic growth. Thus,
correction in balance of payments may be achieved at the expense of
economic growth.
2) Expenditure – Switching Policies: Devaluation:
Another method which used for correcting disequilibrium imbalance of
payments is the use of expenditure -switching policies. Expenditure
switching policies work through changes in relative prices or through
exchange rates. Prices of imports are increased by making domestically
produced goods relatively cheaper. Expenditure switching policies may
lower the prices of exports which will encourage exports of a country. In
this way by changing relative prices, expenditure -switch ing policies help
in correcting disequilibrium in balance of payments. The important form
of expenditure switching policy is the reduction in foreign exchange rate
of the national currency, namely, devaluation. By devaluation we mean
reducing the value or exchange rate of a domestic currency with respect to
other foreign currencies. Devaluation takes place when a country is under
fixed exchange rate system and occasionally decides to lower the
exchange rate of its currency to improve its balance of payments . On the
other hand, in the present flexible exchange rate system, its exchange rate
as determined by demand for and supply of currencies. Fall in the value of
a currency with respect to foreign currencies as determined by demand
and supply conditions is d escribed as depreciation. As a result of reduction
in the exchange rate of a currency with respect to foreign currencies, the
prices of goods to be exported fall, whereas prices of imports go up. This
encourages exports and discourages imports. With export s so stimulated
and imports discouraged, the deficit in the balance of payments will tend
to be reduced.
Marshall Lerner Condition :
According to the Marshall Lerner condition, that whether devaluation or
depreciation will lead to the rise in export earnin gs and reduction in import
expenditure depends on the price elasticity of foreign demand for exports
and domestic demand for imports. Marshall and Lerner condition states munotes.in

Page 37

37 Balance of Trade (Bot) And Balance of Payment (Bop) that devaluation will succeed in improving the balance of payments if sum
of price el asticity of exports and price elasticity of imports is greater than
one. Thus, according to Marshall -Lerner Condition, devaluation improves
balance of payments if
ex + em >1
where ex stands for price elasticity of exports
em stands for price elasticity o f imports
If in case of a country ex + em < 1, the devaluation will adversely affect
balance of payments position instead of improving it. If e x + e m = 1,
devaluation will leave the disequilibrium in the balance of payments
unchanged.
3) Direct Measures :
The countries may also adopt direct measures which will help to restrict
imports or promote exports to bring equilibrium in the Balance of
payment.
a) Tariffs:
Tariffs are duties (taxes) imposed on imports. When tariffs are imposed,
the prices of impor ts would increase to the extent of tariff. The increased
prices will reduce the demand for imported goods and at the same time
induce domestic producers to produce more of import substitutes.
b) Quotas:
Under the quota system, the government may fix and permit the maximum
quantity or value of a commodity to be imported during a given period. By
restricting import through the quota system, the deficit is reduced and the
balance of payments position is improved.
c) Export promotion:
Exports may be encoura ged by reducing export duties and lowering the
interest rate on credit used for financing exports. Exports are also
encouraged by granting subsidies to manufacturers and exporters. Besides,
on export earnings lower income tax can be levied to provide incen tives to
the exporters to produce and export more goods and services. By imposing
lower excise duties, prices of exports can be reduced to make them
competitive in the world markets.
d) Exchange Control:
Under it, all the exporters are ordered to surrende r their foreign exchange
to the central bank of a country, and it is then rationed out among the
licensed importers. No one else is allowed to import goods without a
license. The balance of payments is thus rectified by keeping the imports
within limits. munotes.in

Page 38

38 International Economics
38 4.3 DIFFERENCE BETWEEN BALANCE OF TRADE (BOT) AND BALANCE OF PAYMENTS (BOP) 1) Definition
• Balance of Trade or BoT is a financial statement that takes into
account a country's imports and exports of goods with the rest of the
world.
• Balance of Transaction or BoP is a financial statement that records all
financial transactions of a country with the rest of the world.
2) What does it handle?
• Trade balance deals with the net gain or loss of a country from
imports and exports of goods.
• Current account deals wit h proper accounting of transactions done by
the nation.
3) Fundamental differences
• Balance of Trade (BoT) is the difference between exports and imports
of goods.
• Balance of Transaction (BoP) is the difference between inflow and
outflow of foreign exchange.
4) What kind of transactions are involved
• Commodity related transactions are included in BoT.
• Transactions related to transfer, goods and services are included in
BoP.
5) Is capital transfer involved?
• Trade balance does not include capital transfer.
• Trans actions include capital transfers.
6) What is its net effect?
• The net effect of BoT can be positive, negative or zero.
• The net effect of BoP is always zero.
4.4 PURCHASING POWER PARITY THEORY 4.4.1 Introduction to Purchasing power parity :
This theory has been restated by the Swedish economist Gustav Cassel in
1916, exactly in the years following the First World War, when the
exchange rates are free to fluctuate the rate of exchange between two munotes.in

Page 39

39 Balance of Trade (Bot) And Balance of Payment (Bop) currencies in the long run will be determined by their respecti ve
purchasing powers. According to him:
“The rate of exchange between two currencies must stand essentially
on the quotient of the internal purchasing powers of these currencies.”
Thus, according to the purchasing power parity theory, the exchange rate
between one currency and another is in equilibrium when their domestic
purchasing powers at the rate of exchange are equivalent. E.g. if in India
40 Rs are spent for purchasing 1 kg of apples and in America for the same
kg of apples if one dollar is n eeded to spend, then it is clear that the
purchasing power of both currencies is different in their respective
nations. In order to make equivalent these currencies with each others
units purchasing power will be 1$ = 40Rs.
Once the equilibrium is establis hed, the market forces will operate to
restore the equilibrium if there are some deviations. E.g if the exchange
rate changes to 1$ = 42Rs when the purchasing power of these currencies
remain stable, dollar holder will convert dollars into rupees because, by
doing so, they save Rs. 2 when they purchase a commodity worth $ 1. A
change in the purchasing power of currencies will be reflected in their
exchange rates. For this purpose the price index is made. It is the parity
(equality of the purchasing powers o f the currencies which determines the
exchange rate.
If there is a change in prices (purchasing power of the currencies), the new
equilibrium rate of exchange can be found out by the following formula;
ER = Er x Pd/Pf
Where,
ER = Equilibrium exchange rate
Er = Exchange rate in the reference period
Pd = Domestic price index
Pf = Foreign country‘s price index
Two versions of PPP:
1. Absolute Version:
Under this version, the exchange rate between the currencies of two
nations is established at the point where their purchasing power is equal. It
reflects their domestic purchasing power too. It is calculated as
Rate of exchange = PI / PA
Where,
PI = Prices of certain goods in India
PA = Prices of same goods in another country, say USA. munotes.in

Page 40

40 International Economics
40 Thing to note is that, the changes in internal price level cause changes in
the exchange rate. if inflation is India, then the purchasing power of rupee
in terms of dollars would decline. It is not easy to measure the value of
money in absolute terms.
2. Relative version:
In this m ethod the changes in the purchasing power can be measured by
the changes in the indices of domestic prices of the countries concerned.
Hence the changes in the equilibrium rate can be measured by the ration of
the price indices of the respective countries. in this new equilibrium rate of
exchange can be calculated by multiplying the base period of rate
exchange by the relative changes in the price levels in the two countries
with the help of index numbers.
4.4.2 Evaluation of PPP theory:
 It is based on the unrealistic assumption that international trade is free
from all barriers.
 This theory does not explain the demand for supply of foreign
exchange. While in the free economy the rate is determined by the
forces of demand and supply of foreign exchange.
 The quality of goods and services may vary from country to country,
so comparison of prices without regard to the quality is unrealistic.
 Cost of transport is ignored in this theory.
 It also ignores the impact of international capital movement which
affects on the foreign exchange market.
 The price index number includes the price of all commodities and
services, including those which are not internationally traded and
hence the rate of exchange calculated on the basis of these price
indices cannot be realistic.
 It does not consider the significance of the elasticity‘s of reciprocal
demand.
 This theory is good in long run and lacks its significance in short run.
Check your progress:
1) What is PPP theory? munotes.in

Page 41

41 Balance of Trade (Bot) And Balance of Payment (Bop) 4.5 LAW OF RECIPROCAL DEMAND 4.5.1 Introduction:
The idea of Reciprocal demand was presented by John Stuart Mill in1873
and then it was further developed by Alfred Marshall. Reciprocal demand
means the relative strength and elasticity of demand of the two trading
countries for each other’s product in t erms of their own product. The
theory advocated that the actual price at which trade takes place between
two countries depends on the trading countries interacting demands. It
works similarly as the demand and supply of goods and services in any
other mark et. If demand does not equal to supply in the international
market, the international price will change until it becomes equal. Thus,
equalization of terms of trade depends on the demand and supply
conditions for goods and services in the international mar ket. So the
equilibrium terms of trade is determined by the equation of reciprocal
demand. A stable ratio of exchange is therefore determined by the
equilibrium value of imports and exports of each country.
Theory of reciprocal demand is based on the follo wing assumptions -
(i) Full employment conditions – it assumed that all the resources are
fully employed.
(ii) Perfect competition – exists in the international market.
(iii) Free foreign trade – it assumed no restrictions are imposed on foreign
trade .
(iv) Free mobility of factors – all the factors of production are mobile.
(v) Applicability of the theory of comparative cost – the trade between
the two countries is based on the theory of comparative cost i.e.
production based on specialization.
(vi) Two country, two commodity model – it assumed for simplicity that
the trade takes place between two countries and related to two
commodities.
4.5.2 Changes in Demand and Supply Conditions:
The theory of reciprocal demand analysed the impact of changes in supply
and demand conditions on the terms of trade.
A. Changes in Supply Conditions:
Supply conditions changes due to several causes such as cost -reducing
improvements in technology which bring changes in terms of trade. For
e.g. an improvement in th e textile industry in England increases the
productivity due to which cloth will be cheaper in terms of India’s wheat
i.e. the same amount of wheat is exchanged for more cloth. It thus makes
the terms of trade in favour of India’s importer of cloth in exch ange for
wheat. munotes.in

Page 42

42 International Economics
42 B. Changes in Demand Conditions:
The extent to which the barter terms of trade change depend on the
increased production in exporting country. It also depends on the
importing country’s elasticity of demand for imports in terms of its
exports. In our example suppose,
(i) If elasticity of demand for England’s cloth in terms of India’s own
wheat is more elastic (e1), then the barter terms of trade will change
in favour of India. It can be more than the fall in price of cloth in
terms of wh eat.
(ii) In case of unitary elastic demand (e = 1), the barter terms of trade
turn in favour of India which is equal to the fall in the price of cloth
in terms of wheat.
(iii) If elasticity of India’s demand for cloth in terms of wheat is less
elastic (e 1), then the barter terms of trade will change in favour of
India less than the fall in the price of cloth in terms of wheat.
4.5.3 Criticism of the Mill’s Theory of Reciprocal Demand:
The theory of reciprocal demand has been criticised on the follow ing
grounds:
(i) The very first point of criticism is that the theory is based on
unrealistic assumptions such as perfect competition and full
employment.
(ii) In reality, actual trade is not restricted to two country, two commodity
model but between ma ny countries and many commodities.
(iii) Mill theory concentrates on the aspect of elasticity of demand, and
thus neglected the impact of elasticity of supply. According to the
modem economists, terms of trade (ToT) are generally influenced by
elasticity of demand for exports and imports, elasticity of supply of
exports, and imports.
(iv) Graham has criticised the reciprocal demand aspect of Mill’s theory
by stating that it has exaggerated the role of reciprocal demand and
neglected the comparative cost conditions in determining the terms of
trade.
4.6 MARSHALL – EDGEWORTH OFFER CURVES The offer curves approach is a geometrical technique which uses graphical
representation to determine the equilibrium terms of trade. This technique
is developed by Marshal l. Offer curve is a demand curve which shows the
demand for one commodity in terms of the supply of another commodity.
Generally, it is the demand for import of one commodity in terms of the
supply of export of another commodity. munotes.in

Page 43

43 Balance of Trade (Bot) And Balance of Payment (Bop) Let us assume that India and England, these two countries are trading
partners. India produces only wheat and England only cloth. In the
following diagram, India’s offer curve is presented as OI. It indicates
India’s demand for cloth in terms of wheat. It represents the quantities of
wheat which India is willing to offer in exchange for England’s cloth.
India is willing to offer less and less amount of wheat in exchange for
more and more quantity of cloth. It is seen in the figure that for KW
quantity of cloth India is willing to o ffer OW quantity of wheat.
Figure No. 4.3

England’s offer curve is represented as OE in the diagram which
represents the quantity of cloth England is willing to offer in exchange of
India’s wheat. As it is seen in the diagram England is willing to offer CW
quantity of cloth for OW quantity of wheat to India. T is the equilibrium
point where OIand OE i.e. offer curves of India and England respectively
intersect. The reciprocal demand at this point is equal thereby TP quantity
of England’s cloth is exchange d for OP quantity of India’s wheat. Line OT
represents terms of trade (ToT) line between two countries.
Effect of Change in Supply:
Due to improvement in technology if cost of producing cloth in England
reduces then offer curve of England will shift to t he left and OE1 is
England’s new offer curve. With this shift now England is willing to offer
C1 W cloth for OW wheat, i.e. more cloth by C1 C for same quantity of
OW wheat. The terms of trade (ToT) change is in favour of India as a
result of this improvem ent.
Effect of Change in Demand:
The extent of change in terms of trade is also depend upon the slope of
India’s offer curve. India’s offer curve slopes positively after point T.
Thus TI represents India’s more elastic demand for cloth in terms of munotes.in

Page 44

44 International Economics
44 wheat. It makes the terms of trade in favour of India more than the fall in
cloth’s price in terms of wheat.
Suppose India’s offer curve becomes a vertical straight line after point T
(i.e., TI1), then it shows unitary elastic demand for cloth in terms of wheat
and the terms of trade (ToT) will change in favour of India equal to the
fall in cloth price in terms of wheat. And if India’s offer curve slopes
backward then after point T (i.e., TI2), the terms of trade (ToT) will
change in favour of India more than th e fall in price of doth relative to
wheat.
4.7 GAINS FROM TRADE International trade brings out several benefits to the trading countries. As
put forth in the comparative cost doctrine, if countries produce on the
basis of their specialization, then each c ountry will make optimum use of
their resources by adding into their total output and income.
(a) Optimum use of natural resources:
Natural resources are scarce and having several uses. If we don’t use them
optimally then they will exhaust soon and there won’t be maximum
production. Therefore, a prudent and careful use of the resources is
essential. International Trade makes the optimum use of these scarce
resources possible due to the comparative cost advantage in practice.
When a country produces a comm odity at a lower cost than other
countries, it means it is using the existing resources carefully to produce
more. In this way international trade helps each country to make optimum
use of its natural resources. Each country can concentrate on production o f
those goods for which its resources are best suited so that wastage of
resources will be avoided.
(b) Availability of all types of goods:
Due to scarcity of resources, it is not possible for the countries to produce
all types of goods in required quanti ties at a lower price. But international
trade made it possible to avail all types of goods by importing from the
other countries.
(c) Specialisation:
International trade leads to specialisation. So, it encourages production of
different goods in differen t countries on the basis of their specialisation.
Goods can be produced at a comparatively low cost due to advantages of
division of labour.
(d) Advantages of large -scale production:
In the absence of international trade countries used to produce for
domestic consumption in limited quantity. In international trade countries
produce goods not only for domestic consumption but also for export
purpose i.e. to meet the demand of foreign consumers at large. It therefore
increases their total production where g oods are produced in large scale. munotes.in

Page 45

45 Balance of Trade (Bot) And Balance of Payment (Bop) So the benefits of large scale production are enjoyed by all the
participatory countries in international trade.
(e) Establishment of new industries and technology transfer:
In international trade countries are encourage d to establish new industries
with imported machinery, equipment and technical know -how from the
industrially advanced countries. This helps in the rapid economic
development of the underdeveloped and developing countries.
(f) Increase in efficiency:
In international market, participating countries attempt to produce better
quality goods at minimum possible cost due to stiff competition between
the countries. It leads to increase in overall efficiency and benefits to the
consumers.
(g) Development of tra nsport and communication facilities:
With the establishment of new industries and increase in large scale
production, transportation and communication facilities also developed
rapidly due to international trade.
(h) International co -operation and unders tanding:
For successful international trade, cooperation and understanding between
people of different countries is required. Interaction and exchange of ideas
on regular basis leads to cordial relations between participant countries. It
is beneficial to maintain international peace.
4.8 CASE FOR AND AGAINST FREE TRADE The dictionary definition of free trade states it as a policy of allowing
people of one country to buy and sell from other countries without
restrictions. This idea originated with the influ ential British economist,
philosopher, and author of The Wealth of Nations, Adam Smith. He
inspired the writings of great economists such as David Ricardo, Karl
Marx, Thomas Malthus, and others. According to Smith, specialization
and trade is the best solu tion to create a flourishing American economy.
William H. Peterson, holder of the Lundy Chair of Business Philosophy at
Campbell University, agrees with Smith's philosophy.
Free Trade refers to the Trade between countries without any restriction or
discrim ination. In other words when the citizen of one country are free,
either to import or export or to do both, with the citizens of the country,
then the trade is termed as free. In more precise words, Free Trade is the
restriction less trade among the nation s. Thus in a free trade no
differentiation is made between the national or foreign industries. No
policy exists to favour the national industries and shock the foreign
industries.
Adam Smith defined Free Trade as the, "of commercial policy which
drawn no d istinction between domestic and foreign commodities and munotes.in

Page 46

46 International Economics
46 therefore neither imposes additions burden on the latter, for grants any
special favours to the farmers. "The definition does not however mean that
under the 'Free Trade banner' various duties and lev ies will disappear. But
it means that the duty is to be levied only to raise the revenue and not with
any other purpose like the protection of the interests of the domestic
enterprises.
In the free trade the countries take part because they get the compara tive
advantage by doing so. If the countries are not disturbed in this context
them the trade may become of durable in character. To quote Cairns, "If
nations only engage in trade when advantage arises from doing so any
interference in their free action in trading can only have the effect of
debarring them from an advantage.
Adam Smith Supported the Free Trade, he wrote, if a foreign country can
supply us with a commodity cheaper than we out selves can produce,
better buy it from them with the some part of the produce of our own
industry employed in a way in which we have some advantage. Whether
the advantage which one country has over another be natural or acquired is
in this respect of no consequence. As long as one country has those
advantages and the oth er wants them, it will always be more advantageous
for the latter rather to buy of the former than to make. "
a) Defence Industry on Exception . However, Adam Smith suggested that
the Defence Industry should be an exception to the doctrine. He
considered defen ce to be more important than opulence'.
b) International Trade as an Extension of the Division of Labour. Adam
Smith believed that with the expansion of national industries, division
of labour becomes more and more extensive. Free participation in the
interna tional trade in the field for the expansion of the division of
labour. Free trade also encourages specialisation which is loomed by
the division of labour. Adam Smith wrote, "Individuals find it for
their interest to employ their industry in a way in which they have
some advantage over their neighbours."
c) Best Suited. Adam Smith explained that the free trade is the best
suited to the instinct of the individual. It facilitates every country to
produce and sell the commodities in which it has specialisation. F ree
trade enables the countries to produce the commodity in which they
can have comparative advantage.
d) It is interesting to note Adam Smith's following words, emphasizing
the need for the free trade between the countries:
"In a country which has neither fo reign commerce nor any of the finer
manufactures, great proprietor, having nothing for which he can exchange
the greater part of the produce of his lands which is over and above the
maintenance of the cultivators, consumes the whole in rustic hospitality a t
home. If this surplus produce is sufficient to maintain a hundred or a
thousand men, he can make use of it in no other way than by maintaining a
hundred or a thousand men. He is at all times, therefore, surrounded with a munotes.in

Page 47

47 Balance of Trade (Bot) And Balance of Payment (Bop) multitude of retainers and depend ants who having no equivalent to give in
return or their maintenance, but being fed entirely by his country, must
obey him, for the same reason that soldiers must obey the prince who pays
them. Before the extension of commerce and manufacture in Europe, th e
hospitality of the rich and the great, from the sovereign down to the
smallest baron, exceeded everything which in the present times we can
easily form a nation of West minister hall was the dining room of William
Rufus and might frequently, perhaps not be too large for his company. It
was reckoned a piece of magnificence in Thomas Becket that he strewed
the floor of his hall with clean hay or rushes in the season, in order that the
knights and squares who could not get seats might not spoil their fine
clothes when they sat down on the floor to eat their dinner. The great Earl
of Warwick is said to have entertained every day his different manors
thirty thousand people, and though the number here may have been
exaggerated, it must however, have been very gr eat to admit of such
exaggeration. A hospitality nearly of the same kind was exercised not
many years ago in many different parts of the highlands of Scotland. It
seems to be common in all nations to whom commerce and manufactures
are little known. I have seen says an Arabian chief dine in the streets of a
town where he had come to sell his cattle and invite all passengers, even
common beggars, to sit down with him and partake of his banquet."
Case For Free Trade :
(i) In Free Trade no vested interests are created. All are equal, thus no
industry can claim any special right. No differentiation is adopted in
the governmental policies, which removes any feeling of favouritism.
(ii) Free Trade attracts foreign capital. Foreign capital keeps the national
produc ers alive to their duty and to fight in the competition with them.
There are improvements due to tough competition.
(iii) In Free Trade policy the industrialists need not bribe the legislators
for their protection. The corruption on this front is reduced to the
minimum level.
(iv) Free Trade removes any chances of Monopolistic tendencies. No
temptation emerges in the heart of the home - producers because of the
foreign producers. Thus 'Monopoly -profit earning"' tendency is also
removed.
(v) Free Trade provi des maximum protection to the interests of the
consumers.
(vi) Free Trade leads to fair distribution of wealth. The centralizing
tendencies are removed.
(vii) Free Trade promotes the division and specialization at international
level. It nourishes the feel ings of co -operation among the producers of
different countries. munotes.in

Page 48

48 International Economics
48 (viii) Free Trade removes the feeling of hatred or every against other
nations. It helps in establishing international amity.
Case Against Free Trade :
(i) Free Trade harms the new or infant industries. Due to absence of
protection from the government, new industries find it very difficult
to emerge and compete with the existing industries.
(ii) Free Trade discourages the cottage and small scale industries, since
they find it difficult to comp ete with the large foreign producers.
(iii) According to J.S.Mill, a new industry must be given protection till it
develops. But in the absence of protection it is not possible.
(iv) Free Trade does not help in the diversification of industry.
(v) Free T rade also establishes the domination of the foreign capital and
producers.
(vi) Under Free Trade government cannot create employment
opportunities. It is also harmful for the economic development of the
country.
(vii) Free Trade results into misuse of econ omic resources. Unless there
is protection, national resources cannot be conserved in the national
interest.
(viii) Free Trade also hampers the development of ordinance and defence
industry. Sometimes; "Guns are better than butter, "and "defence is
better than opulence."
(ix) Free Trade nullifies the revenue collection from certain industries. In
Free Trade, revenue cannot be collected according to the needs of
the government.
(x) Free Trade also does not provide any special place tokey industries.
The dev elopment of key -industries is also of basic importance to the
sound economic development.
(xi) Free Trade hampers the feelings of patriotism of using home -made
commodities.
(xii) Free Trade does not make any special provision for the self -
sufficiency.
(xiii) Free Trade encourages unfair competition arising due to dumping
depreciated exchange, etc.
Check Your Progress:
1. Define Free trade. munotes.in

Page 49

49 Balance of Trade (Bot) And Balance of Payment (Bop)
4.9 PROTECTION POLICY Restrictive Trade Policy was advocated, first of all, by the Mercantilists.
Mercantili sts expounded that restriction is the only answer to the adverse
balance of payments. Their policy of restriction was only for the imports
and exports. This theory did not say much about the protection of the
home industries.
The meaning of the term 'prote ction' refers to a set of policies framed to
encourage the home, industries, it is the protection of the home on
industries so that they may prosper rapidly, protectionism involves
following steps:
a. Concessional rates for the home -industries in the case of levies,
duties, etc.
b. Higher rate on levies and duties for the foreign producers.
c. Availability of necessary resources to the home industries.
d. Reservation of national resources for the home industries.
e. Discouraging the consumption of the products of the fore ign
producers.
f. Creation of credit marketing facilities and award of tax concessions to
the home industries.
Thus in simple terms protection means 'step -motherly behaviour' with the
foreign producers. Pelgrave defines Protection as, "The need for
maintainin g economic independence the danger of invasion of foreign
goods and tribute paid to foreign producers from whom goods are
purchased such are well known protectionist place which show by their
form that they have originated in a time of international confli ct. "It is in
the interest of every citizen of the state to allot favour to home made goods
and home industries. To the local citizens he promotion of national
industries and economic interest seem a duty nearly as imperative as the
defence of the national territory against invasion.
The protectionism is more affected by the political ideal than the
economic interest. Protectionism helps in building the national industries
which avoid any kind of foreign interference. A country which is
economically depende nt on foreign products cannot be an independent
country in its political life. Diplomacy, at international level is bound to
affect the national integrity, protectionism helps in diversifying the
resources, building of key industries and providing the nati onal colour to munotes.in

Page 50

50 International Economics
50 the economy. To quote Pelgrave again, "The advantages of diversified
industry of husbanding national resources, or of maintaining certain
industries that would disappear under free trade are not believed to mainly
economic.
Advantages of Pro tection:
Following arguments have been placed forward in favour of
Protectionism. They all support the establishment of Protection as the
accepted trade policy by t he nations; these arguments are :
a. The infant Industry Argument.
b. Diversification of Industry A rgument.
c. The Employment Argument.
d. Conservation of National Resources.
e. The Defence Argument.
f. Key Industry Argument.
g. Patriotism Argument.
h. Self-Sufficiency Argument.
i. The Revenue Argument
j. Fair Economic Life Argument.
1. The Infant Industry Argument :
The staunch s upporter was J. S. Mill. According to him only the infant
industry argument is sound for adopting Protectionism in Theory and
Practice of International Trade. To quote Mill: "A - protective duty
continued for a reasonable time; might sometimes by the best convenient
mode in which a nation can tax itself for the support of such an experim ent
(introducing new industries ). But it is essential that protection should be
confined to cases in which there is good ground of assurance that the
industry which it foste rs, will after a ti me be able to dispense with it. "
This argument has received wide acceptance. In spite of its criticisms this
has been accepted by many countries like USA, UK and India.
2. Diversification of Industry Argument :
This argument was favoured by many German and American Economists :
Frederich List, a German Economist also favoured this argument. For the
rapid development of the economy a country must have varied sources of
income, production when there is employment. Balanced growth is only
possibl e when there is diversification of Industry and resources. If a
country depends on a few industries then it is dangerous for her stability
and independency. Diversification of resources provide ample opportunity
to the labourers to. move from one place to another. Diversification also munotes.in

Page 51

51 Balance of Trade (Bot) And Balance of Payment (Bop) helps in creation of new industries, which in consequent creates new
employment opportunities.
This argument has been criticised on the ground that it removes the
specialising tendencies and the importance of the principle of comparative
costs which are established for the specialisation of a country in the
production of certain commodities.
3. The Employment Argument:
Protection provides ample opportunity for the industrial expansion. In the
absence of protection the home industr y can not expand. This may create
unemployment in the economy. A burning example is the decay of cottage
industry especially the Indian handicrafts; in the 19th century which threw
artisans and workers into the 'mire' of poverty.
4. Conservation of National R esources Argument :
National resources are the costliest assets of a country. In Free Trade, the
export of natural resources may occur which is not fruitful for the
exporting country. American economists Carey and Hatten also argument
against the export of agricultural commodities from America; since it
exhausted the natural quality of the soil. Similar voice was raised by the
British economist Javons, who voted against the export of coal from the
British coal fields. Ruthless exhaustion of resources may mak e the
economy crippled after a period of time.
5. The Defence Argument :
The feeling of protection from external aggression is essential for the
peaceful development of the industries . Adam Smith has once remarked ":
Defence is better than opulence ". The Milit ary strength of an economy is
prior to its development. An active encouragement to defence industries is
a must according to this view. For defence even an uneconomic
distribution of resources is not objectionable.
This argument has been criticised by the advocates of Free Trade on the
ground that it is more a political argument than being an economic one in
its essence.
6. Key Industry Argument :
Development of key Industries is highly essential for providing stability
and basic function to the economic growth . Without their development it
is like jumping into dark. Protection is must for the safe development of
the key industries.
7. Patriotism Argument :
It is the national duty of every citizen to respect home industries by using
and having goods manufactured by the home industries. A step to develop
own industries through protection is essential. Dependence on the foreign
producers keeps one away from being nationalist. munotes.in

Page 52

52 International Economics
52 8. Self-Sufficiency Argument :
This is one of the basic arguments voiced in the favour of Protecti onism.
A country must try to become self -sufficient in all the fields especially in
the field of basic requirements. Protection is a policy for developing the
home industries which could help the economy in becoming self -
sufficient.
9. The Revenue Argument :
Protection has been a good policy for revenue purposes, the imposition of
protective import duties bring handsome revenue. India has been receiving
a large amount of money since such duties were imposed. Here it is
suggested that the revenue must be moderat e and not burdensome.
10. Fair Economic Life Argument :
Protection is necessary to check unfair cut -throat competition. It helps in
bringing the atmosphere healthier.
Disadvantages of Protectionism:
Theory of protectionism has been criticised by the supporters of the
principle of Free -Trade. The criticism of the theory of Protectionism has
been based on the following arguments:
a. Protection creates laziness among the home -industries. In the absence
of foreign competition they do not fight hard to introduce innovat ions
to the old pattern of production. Thus it creates lethargic atmosphere.
b. Protection creates vested interests. Industries, which are granted
protection, starts claiming it as their right in the future. The infants try
to remain infants to use motherly p rotection.
c. Thus utilise the special grant of Protection, industrialists start bribing
the legislators. This was quite frequent in USA when the Principle of
Protection was newly applied there.
d. Monopolies are often created under the cover of Protection. It i s
dangerous for the consumers.
e. There originates two -dimensional industrial policy and management.
One for the Protected and other for the 'Unprotected class' of
industries. This harms the interests of consumers as well as
unprotected class of industries.
f. Protection leads to the centralisation of wealth and wide disparity in
the income level of the people.
g. International transactions become difficult and callous.
h. Protection acts against the division of labour at the international level. munotes.in

Page 53

53 Balance of Trade (Bot) And Balance of Payment (Bop) In spite of these crit icisms, the theory of Protection is far better than the
theory of Free Trade; especially where we come to the practical points of
view. Protectionism is the only principle for the poor and developing
countries including our own big Indian Republic.
While t here will always be necessary adjustments to new and changing
circumstances, free trade between nations ultimately benefits all who
participate. Protectionism can only lead us down a road of
impoverishment and international commercial tensions. To paraphra se the
great 18th -century, free -market thinker, David Hume, when he criticized
the protectionists of his time: Not only as a man, but as an American, I
pray for the flourishing commerce of Germany, France, England and even
Japan. Why? Because America's pro sperity and economic future are
dependent upon the economic prosperity of all of those with whom it
trades in the international division of labour.
4.10 SUMMARY In short, only if the protection policy is followed carefully will its results
be good in the l ong run. It is not easy to choose between these
diametrically opposed policies. However it is not impossible. It is certainly
possible to adopt a flexible policy keeping in mind the needs of the
economy.
4.11 QUESTIONS 1) Explain the causes and solutions of imbalance in balance of payments
(BoP).
2) Explain the difference between balance of trade and balance of
payments.
3) Explain the purchasing power parity theory.
4) Explain the theory of reciprocal demand.
5) Explain Marshall – Edgeworth offer curve
6) Explain the case for or against free trade.
8) Write a note on ‘Protection Policy'.

*****
munotes.in

Page 54

54 MODULE III
5
FOREIGN EXCHANGE MARKET AND
EXCHANGE RATE DETERMINATION
Unit Structure
5.0 Objectives
5.1 Meaning of Foreign Exchange Market
5.2 Functions of Foreign Exchange Market
5.3 Determination of Exchange Rate
5.4 Factors influencing Foreign E xchange Rate
5.5 Summary
5.6 Questions
5.0 OBJECTIVES Relations between different countries are linked through international
trade. Each country has its own currency. Therefore, while doing business
in different countries, currency also has to be exc hanged. Currencies of
different countries are used in international trade. Foreign exchange rate
has gained importance in settling the exchange transactions between two
countries. So in this chapter we are going to study everything related to
foreign excha nge market and foreign exchange rate.
The objectives of this lesson are as follows:
1. To study the meaning and functions of foreign exchange market.
2. To study the nature and components of foreign exchange market.
3. To study exchange rate determinati on.
4. To study the factors affecting the foreign exchange rate.
5.1 MEANING OF FOREIGN EXCHANGE MARKET International trade is a trade which takes place between two or more
countries of the world. It involves exports and imports of goods and
services whic h in turn involves receipts and payments unlike the primitive
economy the exchange of goods and services is no longer carried out
directly on barter basis. Nowadays every country of the world is a
politically sovereign country having independent currency o f its own
which is a legal tender in its territory. This currency doesn‘t act as legal
tender money outside its boundary. The same thing happens in case of
other countries of the globe. Thus different countries of the globe have got
different currencies wh ich circulate as legal tender money in the respective munotes.in

Page 55

55 Foreign Exchange Market And Exchange Rate Determination country viz Rupee in India, Pound Sterling in England, U S Dollar in
USA, Franc in France, Roubles in Russia etc. Therefore whenever a
country buys or sells goods and services from or to another country the
residents of the two countries have to exchange their currencies. Thus the
problem of foreign exchange arises. The importing country, while making
payment to exporting country has to convert its currency in to the
exporting country‘s currency or in to the internationally acceptable
currencies like US Dollar or Pound Sterling. This type of conversion or
transfer is facilitated by the foreign exchange market.
Country for making payments to other countries. It includes all claims
upon foreign currencies. It is a mechanism to the international payments
through which payments are made between two counties having different
currency systems. This mechanism converts domestic currencies to
foreign currencies. It is the international payment mechanism. Foreign
exchange includes foreign currency, foreign cheques and foreign drafts.
Foreign exchange market is the place where currencies are bought and
sold. Institutions like the Treasury, Central Bank, Foreign exchange banks
etc. involved in the purchase and sale of foreign exchange currencies
constitute the foreign exchange market. The transactions in the foreign
exchange market viz. buying and selling foreign currency take at a rate,
which is called ‘Exchange rate’. This market is not any physical place
but a netw ork of communication system connecting the whole complex of
institutions including banks, specialized foreign exchange dealers and
official government agencies through which the currency of one country
can be exchanged for that of another (converted into a nother).
5.2 FUNCTIONS OF FOREIGN EXCHANGE MARKET Following are the three very important functions of the foreign exchange
market: -
1) Transfer Function
2) Credit Function
3) Hedging Function
1] Transfer Function:
The transfer function of a foreign exchange market is also called as money
changing function of a foreign exchange market. It is the main function of
the foreign exchange market. Though this function the foreign exchange
market brings about a transfer of purchasing power between two countr ies.
In order to do that it has to convert one country‘s currency into another
country‘s currency. The international clearing function performed by the
foreign exchange market plays a very important role in facilitating
international trade and internationa l capital movements.

munotes.in

Page 56

56 International Economics
56 2] Credit Function:
It is also one of the most important functions of the foreign exchange
market. Just as domestic trade requires credit to finance trade transactions
when the payment is postponed till future date. Likewise interna tional
trade also requires credit to finance international trade transactions when
the payment is postponed till future date. When the goods are imported it
takes time for the actual delivery of the goods because of shipment and
transportation of goods. Th erefore it entails credit and the credit is
provided by the foreign exchange market. The foreign exchange market
gives loans to the needy countries. Exporters may get pre -shipment and
post shipment credit. Credit facilities are also available for importers . The
Eurodollar market has emerged as a major credit market.
3] Hedging Function:
To hedge means to shoulder risk. It provides a mechanism for both the
exporters and importers to guard themselves against the future fluctuations
in the foreign exchange rat e and the consequent lossless thereof. It is the
function of the foreign exchange market to enter into forward contract to
sell the foreign exchange at a predetermined rate. It assures the party
concerned not to worry about the future changes in the foreig n exchange
rate.
5.3 DETERMINATION OF 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 facil itated
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 come to the
forefront. 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 ex ample 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 we have to correct one
country‘s currency in terms of another country‘s currency which is
effected through the medium of foreign exchange rate. 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.
Since exchange rate is the price of foreign exchange, it is determined by
the demand for and supply of foreign exchange. The following are the
various sources of demand an d supply of foreign exchange: munotes.in

Page 57

57 Foreign Exchange Market And Exchange Rate Determination 1. Demand for Foreign Exchange:
A country would demand foreign exchange for the following purposes:
a. Merchandise Imports: A country requires foreign exchange to pay
for its imports. These are a major source of demand for foreig n
exchange.
b. Import of Services (invisible imports): A country requires foreign
exchange in order to pay for the transport, insurance and banking
services that the residents obtained from other countries. Debt
servicing and amortization are also important s ources of demand for
foreign exchange.
c. Unilateral Receipts: Residents, organisations and government may
receive gifts, donations and grants from other countries.
d. Export of Capital: When residents, institutions and government
invest abroad, they will demand foreign exchange. Since a fall in the
exchange rate increases the demand, the demand, the demand curve
is downward sloping.
2. Supply of Foreign Exchange:
A country obtains foreign exchange from the following sources:
a. Merchandise Exports:
When country e xports its produce to other countries, it will obtain
foreign exchange.
b. Exports of Invisibles:
Countries obtain foreign exchange when they provide transport,
insurance and banking services to other countries. Remittances,
interest received on previous loan s to other countries are also an
important source of supply of foreign exchange.
c. Unilateral Payments:
These are gifts, transfers, and grants from individuals, organisations
and governments to residents, organisations and governments in other
countries.
d. Imports of Capital:
These are borrowings and transfer of reserves from one country to
another. As the price of foreign exchange falls, the supply of foreign
exchange increases, thus the supply curve is upward sloping.
The market exchange rate is determined by the interaction between the
demand and supply of foreign exchange. The following diagram explains
the determination of the exchange rate.
munotes.in

Page 58

58 International Economics
58 Figure 5.1

Exchange Rate R0 Demand & Supply of Foreign Exchange Qe S Df E 150
In the above diagram, we showed th e demand (Df) and supply (Sf) of
foreign exchange. At point E, the demand and supply are equal and Re is
the equilibrium exchange rate.
5.4 FACTORS INFLUENCING FOREIGN EXCHANGE RATE 1. Trade Movements:
Changes in imports and exports will cause a change in the rate of
exchange. If import exceeds exports, the demand for foreign currency rises
and rate of exchange will be unfavorable to the country favourable balance
of payments will raise the exchange value of the currency and vice - versa.
2. Price Trends:
Prices trends in the domestic economy may bring abut fluctuations in
exchange rate e.g. inflation will result in rising prices causing falling
exports. Therefore changes in price within the nation brings effect on the
exchange rates too. Because price fluct uations directly affects the
purchasing power of the consumers for goods and services.
3. Capital Movements:
Export and import of capital will bring about fluctuations in the rate of
exchange. The import of capital will result in increased demand for the
currency of that country in the foreign exchange market and the exchange
value of that currency will rise and vice -versa.
4. Banking operations:
Bank are the major dealers of foreign exchange, the operations of the bank
regarding the changes in the bank ra te, transfer of funds, accepting foreign
bills of exchange, arbitrage etc. affect the demand and hence influence the
exchange rates.
munotes.in

Page 59

59 Foreign Exchange Market And Exchange Rate Determination 5. Political conditions:
Political stability will invite foreign capital and the rate of exchange will
move favorably to t he country. Political instability will cause a flight of
capital resulting in an unfavorable exchange rate for the county.
6. Monetary policy:
An expansionary or contractionary monetary policy may result in inflation
or deflation bringing about changes in the internal and external value of
money. Tariff policy may also bring about fluctuations in exchange rate.
Check Your Progress:
1. Why do exchange rate fluctuate ?
5.5 SUMMARY This chapter explains the meaning of foreign exchange market, various
functions of foreign exchange market, as well as the determination of
exchange rate on the basis of diagrams. Also the meaning of foreign
exchange rate and the factors affecting the foreign exchange rate are
mentioned in detail.
5.6 QUESTIONS 1) Explain the functions of foreign exchange market by explaining the
meaning of foreign exchange market.
2) Explain the determination of exchange rate with the help of diagram.
3) Explain the Factors Affecting Foreign Exchange Rate.

*****
munotes.in

Page 60

67 6
FOREIGN EXCHANGE MARKET:
RELATED TERMS
Unit Structure
6.0 Objectives
6.1 Introduction
6.2 Managed Flexibility
6.3 SWAP Market
6.4 Components of Foreign Exchange Reserves
6.5 Foreign Direct Investment (FDI)
6.6 MNCs
6.7 Questions
6.0 OBJECTIVE S  The objectives of this unit are as follows –
 To know about the concept managed flexibility.
 To study about the SWAP market.
 To understand the components of foreign exchange reserve.
 To know the difference between the foreign aid and foreign trade.
 To study the foreign direct investment.
 To know about the multi -national corporations.
6.1 INTRODUCTION A foreign exchange market facilitates the monetary transactions of foreign
trade. It is a part and parcel of international money market. A foreign
exchange market can‘t be designated by any geographical area or location.
A foreign exchange market can be defined as a mechanism through which
foreign currency can be bought and sold. It comprises of the buyers and
sellers of foreign exchange and the interme diaries through which the
buyers and sellers of foreign exchange are brought to -gether. They deal
with each other through telecommunication network viz. telephones,
mobiles, telexes, and electronic systems. With the advent of advanced
technology like Rente rs Money 2000 – 2 it is possible to access the trader
in any corner of the world within a few seconds. The deal can be done
through electronic devices which allow bid and offer rates to be matched
through central computers.
munotes.in

Page 61

68 Rural Development
68 Participants in the Foreign Exc hange Markets:
The main participants or players in the foreign ex change markets are as
follows:
1) Customers:
The customers who participate in the foreign exchange markets mainly
comprise of the importers and exporters. They participate in the foreign
exchange market by availing of the bank services. The importer has to
make payments to the exporting country in the exporting country‘s
currency hence he utilizes the services of bank to convert its local
currency into exporting country‘s currency. The exp orter also would like
to avail of the services of bank to convert the receipt of foreign currency
into local or domestic currency.
2) Commercial Banks:
Commercial banks facilitate the conversion of one country‘s currency into
another country‘s currency. T he commercial banks are supposed to be the
most active players in the foreign exchange market. These banks have a
wide network of branches or the correspondent banks all over the world
because of which they can transact the foreign exchange business
smooth ly, fastly and efficiently. The importers and exporters belong to
different countries. These banks act as intermediaries between the
importers and exporters. They buy foreign exchange from the exporter and
sell it to the importers.
Commercial banks being the active players in the foreign exchange market
achieve the following objectives: -
i) Profitability:
Foreign exchange business is a profitable activity. The commercial banks
buy the foreign exchange from the exporting country at a lower rate and
sell th e same to the needy importing country at a higher rate. The
difference between these two rates leads to accruing of profit to the
commercial banks.
ii) Risk bearing:
The foreign exchange business entails risk which arises out of fluctuations
in the foreig n exchange rate. This risk is shouldered by the foreign
exchange banks by entering into a contract with the party concerned. It
gets referred to as forward dealing.
iii) Better service:
Commercial banks render better service to the customers by offering
competitive foreign exchange rates.
In India in order to indulge into foreign exchange business the commercial
banks have to obtain license from the Reserve Bank of India under section
6 of Foreign Exchange Regulation Act (FERA), 1973. munotes.in

Page 62

69 Foreign Exchange Market: Related Terms Foreign Exchange Market: Related Terms 3) Central Banks:
The central banks are the main players in the foreign exchange market. It
is one of the functions of the central banks of the world countries to
maintain the external value of the domestic currency. There are two main
types of foreign exchange rate systems viz.
a) fixed exchange rate system and
b) floating or fluctuating exchange rate system.
Under fixed exchange rate system the central bank has to maintain the
parity under floating exchange rate system the central bank as a monetary
and foreign exchange authority of the country has to intervene in to the
foreign exchange market to buy and sel the foreign exchange depending
upon the situation. When the demand for foreign exchange is more then it
releases its foreign exchange reserves and sells foreign exc hange.
Conversely when the supply of foreign exchange happens to be more it
buys foreign exchange from the market. Thus it tries to maintain the
external value of the domestic currency.
4) Bill Brokers:
Bill brokers are the intermediaries who act as liais on between the buyers
and sellers of foreign exchange. Their function is to bring both the parties
together to settle the foreign exchange traction. For performing this
function they get their commission known as brokerage.
5) Discount Houses:
The discoun t houses are the specialized houses specializing in the business
of discounting the foreign bill of exchange. The discount houses discount
the foreign bill of exchange put forwarded by an exporter and finances
him before the maturity of the foreign bill of exchange at a discount. They
retain the foreign bill of exchange till maturity and recover the full value
of the foreign bill of exchange. The London discount houses are the
glaring example of specialized discount houses in the London
International money market.
6) Acceptable Houses:
The Acceptance Houses are the financially well to do firms which have
earned name and fame in the foreign exchange world. When an importer
who is a drawer receives the foreign bill of exchange from the drawer of
the foreign e xchange will be acknowledges the responsibility of involving
payment of the said foreign exchange bill. He being an armature he would
like to put the weight of the acceptance house once that foreign bill of
exchange. The acceptance house lends its name and acknowledges the
responsibility to make the payment of the foreign exchange bill to the
payee on behalf of the drawee. The New York Acceptance Houses are the
world f* acceptance houses which is the special feature of the New York
International Money Marke t. munotes.in

Page 63

70 Rural Development
70 6.2 MANAGED FLEXIBILITY Managed flexibility means the system of controlled flexibility to foreign
exchange rate. The system of managed flexibility is a golden mean, a via
media between the two extreme situations of foreign exchange rate
systems viz.
i) the fixed exchange rate system and
ii) the flexible exchange rate system.
As a matter of fact the system of managed flexibility emerged out of the
drawbacks of both the foreign exchange rate systems.
In the managed flexibility the Govt. is called upon to play a very important
role of intervening in the foreign exchange market. The central bank of the
country being the monetary and foreign exchange authority of the country
intervenes into the foreign exchange market.
As per the managed flexibility the foreign exc hange rate is allowed to
fluctuate but within limit. Hence it is also called as controlled flexibility.
Figure 6.1

OR is the equilibrium foreign exchange rate. When the foreign exchange
rate fluctuates around the equilibrium foreign exchange rate then th e
central bank intervenes into the foreign exchange market. When the
demand for foreign exchange rises the central bank releases its foreign
exchange reserve and sells the foreign exchange in to the market to tide
over the increased demand for foreign exch ange. Conversely when the
supply of foreign exchange rises it buys the foreign exchange from the
market. Thus the central bank keeps the fluctuations in the foreign
exchange rate within limit.
The managed flexibility can be of three types.
i) Adjustable Peg System
ii) Crawling Peg System munotes.in

Page 64

71 Foreign Exchange Market: Related Terms Foreign Exchange Market: Related Terms iii) Managed floating.
The adjustable Peg System believes in the fixed rate of exchange up to a
certain point -beyond which it doesn‘t stick to it and hence switches over to
adjustable Peg System. So long as a country possessed adequate foreign
exchange reserves it sticks to fixed exchange rate. Afterwards a country
may resort to devaluation of the currency by lowering down the foreign
exchange value of the domestic currency. In short it recommends a little
flexibility in the midst of stability of exchange rate. Thus this system
possesses the duel characteristics of stability and flexibility.
In the Crawling Peg System on and after adjustment is made in the fixed
exchange rate system due to changes in the market condit ions of demand
and supply. But it recommends only mild devaluation and not extreme
devaluation.
A system of managed floating believes in Governmental intervention for a
quick and reasonable adjustment in the foreign exchange rate.
Check Your Progress:
1. What is managed flexibility?
6.3 SWAP MARKET The swap operations are undertaken by the commercial banks in the
foreign exchange market. The term swap means simultaneous sale of spot
currency or the purchase of the spot currency for the forward s ale of the
same currency. The simultaneous sale or purchase of spot currency for
forward delivery, are technically known as swaps. The swap mean double
deal. The spot currency is swapped against forward.
6.4 COMPONENTS OF FOREIGN EXCHANGE RESERVES Just as an individual has to be in a position to pay his debts. in order to pay
the debts a person must have his own income. In the same way every
nation has to pay for the imports of goods and services. To settle the
international obligation a nation must have ad equate foreign exchange
reserves. In order to accumulate foreign exchange reserves a nation must
earn foreign exchange by exporting goods and services. The reserves are
generally hold in the form of gold, Dollar, Pound Sterling and other strong
or reserve carries of the world plus other international financial assets,
S.D. Rs. etc. munotes.in

Page 65

72 Rural Development
72 There is a linkage between the growth of international trade and the
growth of foreign exchange reserves. With the growth of international
trade foreign exchange reserve also gro ws. When the demand for foreign
exchange reserve matches with the supply of foreign exchange reserves
then there will be no problem of foreign exchange reserve. The problem of
foreign exchange reserve crops up when the demand for foreign exchange
reserves exceeds the supply of foreign exchange reserves.
Concept:
The term foreign exchange reserves is associated with the system of
international payments of a country. It is a part and parcel of International
liquidity.
There is a difference between the term i nternational liquidity and the term
foreign exchange reserves. The term international liquidity is a broad term
which encompasses foreign exchange reserves while foreign exchange
reserves is a very narrow term in the realm of meeting the balance of
payment s deficit and settling other international obligation. It is a part and
parcel of international liquidity. International Liquidity refers to generally
accepted means of international payments available to a country for the
settlement of international trans actions. This International Liquidity
comprises of two elements viz.
i) Owned reserves and
ii) Borrowing facilities
Of these two elements the foreign exchange reserves constitute the first
one i.e. owned reserves. Hence it forms as only one fragment of
International Liquidity.
International reserves of a country comprise of
i) Official holdings of gold
ii) foreign exchanges like U.S. Dollar Pound Sterling and other strong or
reserve currencies of the world countries.
iii) Special Drawing Rights (SDRs )
iv) Reserve Position in IMF.
Note: - The international reserves do not include private holdings of gold,
private holdings of foreign exchange and private holdings of international
financing assets.
6.5 FOREIGN DIRECT INVESTMENT (FDI) 6.5.1 Meaning of FDI :
A Foreign Direct Investment (FDI) is an investment made by a firm or
individual in one country into business interests located in another
country. With FDI, foreign companies are directly involved with day -to-munotes.in

Page 66

73 Foreign Exchange Market: Related Terms Foreign Exchange Market: Related Terms day operations in the other country. FDIs, ap art from being involved in
capital investment, also include the provisions of management or
technology. The key feature of FDI is that it establishes either effective
control of or at leasta substantial influence over the decision -making of the
foreign bus iness. The FDI can be made in various ways, including the
opening of a subsidiary or associate company in a foreign country or
ensuring a merger or joint venture with a foreign company.
6.5.2 Types of FDI:
 FDI can be categorised into horizontal, vertical or conglomerate.
 A horizontal direct investment happens when an investor sets up the
same type of business operation in a foreign country as it operates in
its home country.
 A vertical investment is one in which different, but related business
activities from the investor’s main business is established or acquired
in a foreign country. For instance, when a manufacturing company
acquires an interest in a foreign company that supplies parts or raw
materials required for the manufacturing its finished goods, it is called
vertical investment.
 A conglomerate type of FDI is the one where a company or an
individual makes foreign investment in a business that is unrelated to
its existing business in its home country.
 Since this type of investment involves entering a new industry where
the investor has no experience, it often takes the form of a joint
venture with a foreign company already operating in the country.
6.5.3 Advantages and disadvantages of FDI:
What are the advantages of FDI?
i) Increase in production:
Allowing FDI inflow ensures an increase in investment in key areas such
as infrastructure development, which may lead to increase in capital goods
production. For instance, investment in power generation can generate
more electric power, which would enable the growth of more industries.
ii) Increase in capital inflow:
FDI promotes more capital inflow into the countries, especially in key
sectors like infrastructure .It can address the shortage of capital and
materials, which can rapidly enhance the growth o f the country.
iii) Increase in employment opportunities:
FDIs in developing countries have enhanced the service sectors. This
increased the employment opportunities within these countries, leading to
an increase in economic growth. Educated unemployment h as also been
reduced by the FDIs as they can absorb some of the workforces. munotes.in

Page 67

74 Rural Development
74 iv) Strengthening of financial services:
FDIs can enhance financial services of a country by not only entering its
banking industry but also by extending other activities like merc hant
banking, portfolio investment etc.It has also helped the capital market
within the country.
v) Exchange rate stability:
RBI has been maintaining the exchange rate in the country through its
exchange control measures. However, the constant and continuo us supply
of foreign exchange is vital for the continuation of exchange rate stability.
FDI inflow plays a crucial role in this aspect by helping RBI to have
comfortable foreign exchange reserve position of more than 1 billion
dollars.
vii) Economic develo pment:
FDIs, in the past, have played a crucial role in developing backward areas
by starting industries. This resulted in many of these areas becoming
industrial centres, with improvement in the standard of living of the people
in these areas.
viii) Effic ient use of natural resources:
The natural resources in the country can be used efficiently by the FDI,
which may otherwise have been unutilised.
ix) Improved knowledge and technology:
One of the crucial benefits received by the host countries through the FDIs
is access to new technologies and expertise from foreign companies. This
can result in enhancement of the country’s growth potential.
x) Maintenance of Balance of Payments:
FDI growth can help maintain the Balance of Payments. It can also
maintain the value of countries’ currencies.
What are the Disadvantages of FDI?
 Foreign ownership of strategically important sectors cannot favour the
countries.
 Foreign investors might strip the business of its value.
 They could sell unprofitable portions of the comp any to the local, less
sophisticated investors.
 They can use the company’s collaterals to get low -cost, local loans.
 Instead of reinvesting it, they lend the funds back tothe parent
company. munotes.in

Page 68

75 Foreign Exchange Market: Related Terms Foreign Exchange Market: Related Terms  The MNCs, through FDIs, can get controlling rights within the
foreign countries.
 FDI can also be a convenient way to bypass local environmental laws.
 Developing countries are tempted to reduce environmental regulations
to attract FDI inflows.
 FDI does not always benefit host countries as it enables foreign
multinational s to gain from ownership of raw materials and even
exploit labour force by not distributing its wealth to the backward
society.
 MNCs are often criticised for their poor working conditions in foreign
countries.
 The entry of large firms can often displace lo cal businesses and may
drive them out, as these small companies cannot compete.
6.5.4 FDI policy in India :
New Industrial policy 1991 :
The Government introduced automatic approval upto 51% of foreign in 34
priority sectors. Government had the authority to raise FDI limit to 100%
without prior approval of Parliament.
There were 2 ways to get FDI approval in India .
Automatic Route:
Under the Automatic Route, the non -resident investor or the Indian
company does not require any approval from Government of Ind ia for the
investment.
Government Route:
Under the Government Route, prior to investment, approval from the
Government of India is required. Proposals for foreign direct investment
under Government route, are considered by respective Administrative
Ministr y/ Department.
FDI policy 2017: On August 28, 2017 , DIPP announced the revised FDI
policy. The following initiatives were taken.
 Abolition of FIPB and establishment of Foreign Investment
Facilitation portal.
 Different departments were appointed to look into sector specific
investments .
 DIPP issued Standard operating Procedures with detailed procedures,
the timelines and list of competent authorities for government
approval. munotes.in

Page 69

76 Rural Development
76  Start -ups could issue equity or equity linked debt instruments to
foreign ven ture capital investors.
Trends of FDI in India
 The Measures taken by the Government on the fronts of FDI policy
reforms, investment facilitation and ease of doing business have
resulted in increased FDI inflows into the country as India has
attracted tota l FDI inflow of US$ 72.12 billion during April to
January, 2021.
 It is the highest ever for the first ten months of a financial year and
15% higher as compared to the first ten months of 2019 -20 (US$
62.72 billion).
 The trends show that the FDI equity in flow grew by 28% in the first
ten months of F.Y. 2020 -21 (US$ 54.18 billion) compared to the year
ago period (US$ 42.34 billion).
 In terms of top investor countries, ‘Singapore’ is at the apex with
30.28% of the total FDI Equity inflow followed by U.S.A ( 24.28%)
and UAE (7.31%) for the first ten months of the current financial year
2020 -21.
 Japan has been leading the list of investor countries to invest in India
with 29.09% of the total FDI Equity inflows during January, 2021,
followed by Singapore (25.46 %) and the U.S.A. (12.06%).
 The Computer Software & Hardware has emerged as the top sector
during the first ten months of F.Y. 2020 -21 with 45.81% of the total
FDI Equity inflow followed by Construction (Infrastructure)
Activities (13.37%) and Services Se ctor (7.80%) respectively.
 As per the trends shown during the month of January, 2021, the
consultancy services emerged as the top sector with 21.80% of the
total FDI Equity inflow followed by Computer Software & Hardware
(15.96%) and Service Sector (13.64 %).
 These trends in India’s Foreign Direct Investment are an endorsement
of its status as a preferred investment destination amongst global
investors .
6.6 MNCS 6.6.1 Meaning of Multinational Companies (MNCs):
A multinational company is one which is incorpo rated in one country
(called the home country); but whose operations extend beyond the home
country and which carries on business in other countries (called the host
countries) in addition to the home country.
munotes.in

Page 70

77 Foreign Exchange Market: Related Terms Foreign Exchange Market: Related Terms Features of Multinational Corporations (MNCs):
(i) Huge Assets and Turnover:
Because of operations on a global basis, MNCs have huge physical and
financial assets. This also results in huge turnover (sales) of MNCs. In
fact, in terms of assets and turnover, many MNCs are bigger than national
economies of several countries.
(ii) International Operations Through a Network of Branches:
MNCs have production and marketing operations in several countries;
operating through a network of branches, subsidiaries and affiliates in
hostcountries.
(iii) Unity of C ontrol:
MNCs are characterized by unity of control. MNCs control business
activities of their branches in foreign countries through head office located
in the home country. Managements of branches operate within the policy
framework of the parent corporati on.
(iv) Advanced and Sophisticated Technology:
Generally, a MNC has at its command advanced and sophisticated
technology. It employs capital intensive technology in manufacturing and
marketing.
(v) Professional Management:
A MNC employs professionally tra ined managers to handle huge funds,
advanced technology and international business operations.
(vi) Better Quality of Products:
A MNC has to compete on the world level. It, therefore, has to pay special
attention to the quality of its products.
6.6.2 Advan tages and Limitations of MNCs:
Advantages of MNCs
(i) Employment Generation:
MNCs create large scale employment opportunities in host countries. This
is a big advantage of MNCs for countries; where there is a lot of
unemployment.
(ii) Automatic Inflow of F oreign Capital:
MNCs bring in much needed capital for the rapid development of
developing countries. In fact, with the entry of MNCs, inflow of foreign
capital is automatic. As a result of the entry of MNCs, India e.g. has
attracted foreign investment with several million dollars. munotes.in

Page 71

78 Rural Development
78 (iii) Proper Use of Idle Resources:
Because of their advanced technical knowledge, MNCs are in a position to
properly utilise idle physical and human resources of the host country.
This results in an increase in the National Incom e of the host country.
(iv) Improvement in Balance of Payment Position:
MNCs help the host countries to increase their exports. As such, they help
the host country to improve upon its Balance of Payment position.
(vi) Technical Development:
MNCs carry the advantages of technical development In fact, MNCs are a
vehicle for transference of technical development from one country to
another.
(vii) Managerial Development:
MNCs employ latest management techniques. People employed by MNCs
do a lot of research in m anagement. In a way, they help to professionalize
management along latest lines of management theory and practice. This
leads to managerial development in host countries.
(viii) End of Local Monopolies:
The entry of MNCs leads to competition in the host co untries. Local
monopolies of host countries either start improving their products or
reduce their prices. MNCs compel domestic companies to improve their
efficiency and quality.
(ix) Improvement in Standard of Living:
By providing super quality products an d services, MNCs help to improve
the standard of living of people of host countries.
(x) Promotion of international brotherhood and culture:
MNCs integrate economies of various nations with the world economy.
Through their international dealings, MNCs prom ote international
brotherhood and culture; and pave way for world peace and prosperity.
Limitations of MNCs :
(i) Danger for Domestic Industries:
MNCs, because of their vast economic power, pose a danger to domestic
industries; which are still in the proces s of development. Domestic
industries cannot face challenges posed by MNCs. Many domestic
industries have to wind up, as a result of threat from MNCs. Thus MNCs
give a setback to the economic growth of host countries.

munotes.in

Page 72

79 Foreign Exchange Market: Related Terms Foreign Exchange Market: Related Terms (ii) Repatriation of Profits:
MNCs ear n huge profits. Repatriation of profits by MNCs adversely
affects the foreign exchange reserves of the host country; which means
that a large amount of foreign exchange goes out of the host country.
(iii) No Benefit to Poor People:
MNCs produce only those things, which are used by the rich. Therefore,
poor people of host countries do not get, generally, any benefit, out of
MNCs.
(iv) Danger to Independence:
Initially MNCs help the Government of the host country, in a number of
ways; and then gradually start interfering in the political affairs of the host
country. There is, then, an implicit danger to the independence of the host
country, in the long -run.
(v) Disregard of the National Interests of the Host Country:
MNCs invest in most profitable sectors; and disregard the national goals
and priorities of the host country. They do not care for the development of
backward regions; and never care to solve chronic problems of the host
country like unemployment and poverty.
(vi) Careless Exploitation of Natural Re sources:
MNCs tend to use the natural resources of the host country carelessly.
They cause rapid depletion of some of the non -renewable natural
resources of the host country. In this way, MNCs cause a permanent
damage to the economic development of the hos t country.
(vii) Exploitation of People, in a Systematic Manner:
MNCs join hands with big business houses of host country and emerge as
powerful monopolies. This leads to concentration of economic power only
in a few hands. Gradually these monopolies make it their birth right to
exploit poor people and enrich themselves at the cost of the poor working
class.
6.7 QUESTIONS 1) Explain the concept of managed flexibility with diagram.
2) Write a detailed note on swap market.
3) Explain the components of for eign exchange reserves. .
4) Write a note on Foreign Direct Investment (FDI).
5) Explain the merits and demerits of multinational companies.
***** munotes.in

Page 73

80 MODULE IV
7
INTERNATIONAL ECONOMIC
INSTITUTIONS
Unit Structure
7.0 Objectives
7.1 Introduction
7.2 International Monetary Fund (IMF)
7.2.1 Role of International Monetary Fund (IMF)
7.2.2 Functions of International Monetary Fund (IMF)
7.3 World Bank
7.3.1 Role of World Bank
7.3.2 Functions of World Bank
7.4 World Trade Organization (WTO)
7.4.1 Objectives of World Trade Organization (WTO)
7.4.2 Functions of World Trade Organization (WTO)
7.4.3 Agreements of World Trade Organization (WTO)
7.4.3.1 TRI PS
7.4.3.2 TRIMS
7.4.3.3 GATS
7.4.3.4 AoA
7.5 Summary
7.6 Questions
7.0 OBJECTIVES • To understand the role and functions of International Monetary Fund.
• To study the role and functions of the World Bank.
• To review the objectives, functions a nd agreements of the World
Trade Organization.
7.1 INTRODUCTION From the early 19th century till the past First World War period most of
the industrialized countries of the world followed gold standard. Under
gold standard each country following gold stand ard expressed its currency
in terms of gold. In 1900 for example the dollar was equal to 1/20lh ounce
of gold and the Pound sterling was equal to 5/20th ounce of gold. Hence
1£=S5. Secondly the countries also agreed to convert its paper currency in
the gol d on demand. Thirdly there was no restriction on the shipment of munotes.in

Page 74

81 International Economic Institutions gold from one country to another. The gold standard provided for an
automatic corrector of balance of payments disequilibrium. If the country
imported goods more than its exports then gold fl owed out.
Conversely when a country exported goods more than its imports gold
flowed in. Many supply in the country also depended on the receipt and
payment of gold. In case receipt of gold money supply expanded in the
country conversely in case of payment of gold money supply contracted in
the country. The increase in money supply led to increase in prices. While
the contraction in money supply led to fall in the price level. Until the
outbreak of First World War (1914) the gold standard worked remarkably
well and the stability in the exchange rate was maintained. Gold standard
countries were very eager to abide by the golden rule of gold standard to
expand money and credit. When it coming in and to contract the volume
of money and credit when gold is going out. The gold standard was,
shattered in the first week of first world war (1914 -1918). The conversion
of paper currency notes in the gold was prohibited and the import and
export of gold was stopped. After the First World War the international
gold stand ard was restored line due to the following reasons:
i) There was a natural wish to return to normalcy
ii) People wished to go back to pre -war conditions
iii) Post war inflation
However, after a decade the international gold standard once again was
abandoned by major ity of the world countries due to 1930's great
depression. Great Britain suspended international gold standard in 1931
followed by majority of the countries of the world including U.S.A.
The breakdown of the international gold standard created a vacuum in the
field of international trade. All the countries of the world realised the need
for international economic co -operation. The breakdown of international
gold standard created a chaos in the field of foreign exchange rates. In
order to take the advantage of increase in exports each country
deliberately switched over to competitive devaluation. Each country tried
to prosper at the cost of the other. They followed, "beggar thy neighbour
policy." Competitive devaluation, exchange controls, import quota, tarif fs
73, export regulations and bilateral pacts were the order of the day. Thus
the volume of international trade declined to a considerable extent. Due to
uncertainly, international investment suffered a lot.
It was realised that mutual agreements between w orld countries having
international economic relation would solve the problem of international
monetary disorder. International monetary Co -operation became the need
of the hour. It was impossible to revive the international gold standard, a
new system had to we devised which would provide sufficient flexibility
through international assistance without disturbing the internal economies.
Different nations put forwarded different plans to solve the problem of
international trade and monetary disorder, in 1943 the United States
Treasury published a proposal for the establishment of an International munotes.in

Page 75

82 International Economics
82 stabilization Fund of the United and Associated Nations. Great Britain
also proposed the establishment of an International clearing union. The
American proposal was known as "white plan" while the British proposal
was known as, "Keynes plan". The author of "white plan" was Mr. White
while the author of "Keynes plan" was Lord J.M. Keynes. In 1944 a joint
plan in the shape of" Joint statement by Experts on the Establish ment of
International Monetary Fund of the United and Associated Nation"
emerged which become the basis for the United Nations monetary and
Financial conference. Which was held at Bretton woods, New Hampshire
from July 1 to July 22, 1944. The purpose of th e Bretton woods
conference was to devise means for assuring a system of international
trade and payments consistent with the dual objections of high world
productivity and trade and domestic income and employment with
economic stability. At the meeting it was decided that an 'International
Monetary Fund (IMF)' be organised for the smooth settlement of
international payments.
7.2 INTERNATIONAL MONETARY FUND (IMF) The IMF was organised in 1946 and it commenced its operation in March
1947. The International mo netary system introduced at Bretton woods
rested on two pillars viz. the maintenance of stable exchange rates and a
multilateral credit mechanism institutionalized in he IMF and supervised
by it. The International Monetary System that existed from 1947 to 1971
in generally known as the par value system or pegged exchange rate
system. Under this system each member country of IMF is required to
define the value of its currency in terms of gold or U.S. dollar and to
maintain (to peg) the market value of its cu rrency within ± of the defined
par value. The value of US dollar was set at 1/ 35 of an ounce of gold and
the limited states promised that all US dollars in the hands of central banks
would be redeemed in gold, up on demand at the fixed price of $ 35 per
ounce of gold. Every country defined its currency in items of gold or
dollar. The dollar was not merely as good as gold, but it was better than
gold because dollar reserves earned interest while gold did not. The
exchange rate between two currencies would n ot remain constant for -ever.
It would change under following conditions:
i) A member shall not propose to change except to correct the
fundamental disequilibrium in the balance of payments and it shall act
only after consultation with IMF.
ii) The fund will not object to change not exceeding 10% of the initial
par value.
iii) It a change in proposed exceeding 10% but not exceeding 20% of the
initial par value. The IMF may agree or object but must declare its
attitude within 72 hours.
iv) If the proposed change is longer than 20% the Fund may concur or
object without limit of time. munotes.in

Page 76

83 International Economic Institutions v) The Fund must agree "if it is satisfied that the change is necessary to
correct fundamental disequilibrium in the balance of payments.
Concept And Meaning Of Imf:
The international monetary f und is a landmark in the history of
international monetary Co -operation. It is an international Financial
Institution. The abbreviation IMF stands for International Monetary Fund.
The International Monetary Fund (IMF) is an organization of countries
that s eeks to promote international monetary co -operation. It facilitates the
expansion of international trade. Thus, it contributes towards increased
employment and improved economic conditions in all member countries.
Membership of IMF is open to -every country of the world that controls its
foreign relations and is able and prepared to fulfill the obligations of
membership. Membership of IMF is a pre - requisite for membership in
the IBRD i.e. the World Bank. There is a close relationship between the
IMF and th e IBRD. The Fund is a specialized agency within the United
Nation system, it cooperates with the UN on matters of mutual interest.
The IMF can be designated as a central bank of central Banks of the world
countries because it collects the resources and mai ntains the reservoir of
nation‘s currencies just like that of the central bank of a country which
collects cash reserves of the commercial banks of the country. However,
there is a difference in the functioning of the central bank of the respective
countri es and IMF. The central banks of the world countries can control
the volume of money and credit through the monetary policy while IMF
can't control the volume of money and credit of any member country.
7.2.1 Role of International Monetary Fund (Imf) :
Since the onset of the global economic crisis in 2007, The IMF introduced
several changes in its lending reforms, policy of lending aid to poor
countries, governance reforms, conditionality‘s of getting funds etc. which
are as follows:
1) Governance Reform:
On December 15, 2010, the Board of Governors approved far -reaching
governance reforms under the 14th General Review of Quotas. The
package includes a doubling of quotas, which will result in more than a 6
percentage point shift in quota share to dynamic emer ging market and
developing countries while protecting the voting shares of the poorest
member countries. The reform will also lead to a more representative,
fully -elected Executive Board. Changes in Conditionality of Fund: The
conditionality of IMF are no longer set in quantitative targets such as
reducing fiscal expenditure, or contracting the supply of credit to bring
aggregate demand in balance with the aggregate supply. The
conditionality‘s are now set in qualitative targets such as structural
reforms, passing of new legislations such as bankruptcy codes, reform of
tax administration and removing rigidities that hold back growth.
munotes.in

Page 77

84 International Economics
84 2) Credit line for strong performers:
The Flexible Credit Line (FCL), introduced in April 2009 and further
enhanced in Augus t 2010, is a lending tool for countries with very strong
fundamentals that provides large and upfront access to IMF resources, as a
form of insurance for crisis prevention. There are no policy conditions to
be met once a country has been approved for the c redit line. Colombia,
Mexico, and Poland have been provided combined access of over $100
billion under the FCL (no drawings have been made under these
arrangements). FCL use has lead to lower borrowing costs and increased
room for policy scheme. Structural performance criteria have been
discontinued for all IMF loans, including for programs with low -income
countries. Structural reforms will continue to be part of IMFsupported
programs, but have become more focused on areas critical to a country‘s
recovery.
3) Social Safety Net Programs:
The IMF is promoting measures to increase spending on, and improve the
targeting of, social safety net programs that can mitigate the impact of the
crisis on the most vulnerable in society.
4) Reforms in the Lending Framewor k of the IMF:
To provide better support to countries during the global economic crisis,
the IMF beefed up its lending capacity and approved a major overhaul of
how it lends money by offering higher amounts and tailoring loan terms to
countries‘ varying st rengths and circumstances.
5) Policies for Low Income Countries:
In response to the global financial crisis, the IMF undertook policy
reforms toward lowincome countries. As a result, IMF programs are now
more flexible and modified to the individual needs of low -income
countries, with streamlined conditionality, higher concessions and more
emphasis on safeguarding social spending.
6) Availability of Resources:
Resources available to low -income countries through the Poverty
Reduction and Growth Trust over the period 2009 –2014 were boosted to
$17 billion, consistent with the call by G -20 leaders in April 2009 of
doubling the IMF‘s concessional lending capacity and providing $6 billion
additional concessional financing over the next two to three years. The
IMF‘s concessional lending to low -income countries amounted to $3.8
billion in 2009, an increase of about four times the historical levels. In
2010 and 2011, concessional lending reached $1.8 billion and $1.9 billion
respectively.

munotes.in

Page 78

85 International Economic Institutions 7) Establishment of a P ost-Catastrophe Debt Relief (PCDR) Trust:
This allows the IMF to join international debt relief efforts for very poor
countries that are hit by the most catastrophic of natural disasters. PCDR -
financed debt relief amounted to $268 million in 2010.
8) Effor ts against Global Crisis:
As a key part of efforts to overcome the global financial crisis, the Group
of Twenty industrialized and emerging market economies (G -20) agreed
in April 2009 to increase borrowed resources available to the IMF
(complementing its quota resources) by up to $500 billion (which tripled
the total pre -crisis lending resources of about $250 billion) to support
growth in emerging market and developing countries. In April 2010, the
Executive Board adopted a proposal on an expanded and mor e flexible
New Arrangements to Borrow (NAB), by which the NAB was expanded
to about SDR 367.5 billion (about $560 billion), with the addition of 13
new participating countries and institutions, including a number of
emerging market countries that made sign ificant contributions to this large
expansion. On November 15, 2011, the National Bank of Poland joined
the NAB as a new participant, bringing the total to about SDR 370 billion
(about $570 billion) and the number of new participants to 14 (once all
new pa rticipants have joined). In addition to increasing the Fund‘s own
lending capacity, in 2009, the membership agreed to make a general
allocation of SDRs equivalent to $250 billion, resulting in a near ten -fold
increase in SDRs. This represents a significant increase in own reserves
for many countries, including low -income countries.
9) Sharpening of IMF Analysis and Policy Advice:
To try and prevent future crises, the IMF is working closely with
governments and other international institutions. Risk analys is has been
enhanced, including by taking a crosscountry perspective, and early
warning exercises are being carried out jointly with the Financial Stability
Board. Analyses on linkages between the real economy, the financial
sector, and external stability are being strengthened. Work has also been
done on mapping and understanding the implication of rising financial and
trade interconnectedness for surveillance and for lending to strengthen the
global financial safety net.
7.2.2 Functions Of International M onetary Fund (Imf) :
The fundamental objective of the IMF was the avoidance of competitive
devaluation and exchange control. Basically there are three general
objectives of IMF viz.
i) The elimination or reduction of existing exchange controls.
ii) The establish ment of maintenance of currency convertibility with
stable exchange rates.
iii) The establishment of multilateral trade and payments. munotes.in

Page 79

86 International Economics
86 Objectives As per the Article 1 of the IMF Agreement are as follows:
 To promote international monetary co -operation through a permanent
institution which provides machinery for consultation and
collaboration on international monetary problems.
 To facilitate the expansion of balanced growth of international trade
and to contribute thereby to the promotion and maintenance of high
level of employment and real income and to the development of the
productive resources of all member countries as the primary objective
of economic policy.
 To promote exchange stability to maintain orderly exchange
arrangements among members and to avoid competitive exchange
depreciation.
 To assist in the establishment of a multilateral system of payments is
respect of current transactions between member countries and in the
elimination foreign exchange restrictions which hamper the growth of
world trade.
 To lend confidence to members by making the Fund resources
available to them under adequate safeguards, thus providing them
with opportunity to correct mal adjustments in the balance of
payments without resorting to measures destructive to national and
international prosperity.
 In accordance with the above to shorten the duration and lessen the
degree of disequilibrium in the balance of payments of the member
countries.
Functions of IMF:
To fulfill the above objectives, the IMF performs the following f unctions:
1. The IMF operates in such a way as to fulfil its objectives as laid down
in the Bretton Woods Articles of Agreements. It is the IMFs duty to to
see that these provisions are observed by member countries. Some of
the provisions of the original Arti cles such as relating to exchange
rates have become obsolete due to international monetary events.
Accordingly IMF has amended its Articles of Agreement to make
appropriate adjustment.
2. The fund gives short -term loans to its members, so that they may
correc t their temporary balance of payments disequilibrium.
3. The fund is regarded as ‗the guardian of good conduct‘ in the sphere
of balance of payments. It aims at reducing tariff and other trade
restrictions by the member countries. Article VII of the Charter
provides that no member shall ,without the approval of the fund,
imposes restrictions on the making of payments or engage in
discriminatory currency arrangement or multiple currency practices. It munotes.in

Page 80

87 International Economic Institutions is the functions of the IMF to have surveillance of the policies being
adopted by the member countries.
4. The fund al so renders technical advice to its members on monetary
and fiscal policies.
5. It conducts research studies and publishes them in IMF staff papers,
Finance and Development, etc.
6. It provides technical experts to member countries having balance of
payment diffi culties and other problems.
7. It also conducts short training courses on fiscal, monetary and balance
of payments for personnel from member nations through its Central
Banking Services Development, the Fiscal Affairs Department, the
Bureau of Statistics and the IMF institute.
Thus the Fund performs Financial, Supervisory and Controlling functions.
7.3 WORLD BANK World Bank is a bank established by 148 countries of the world to provide
financial assistance to developing countries for their development. This
World Bank is also known as International Bank for Reconstruction and
Development (IBRD). The office of this bank is in Washington.
Development funds are given to underdeveloped and third world countries
through this bank. It provides loans and technical as sistance. Economic
policies are important in international politics. Therefore, developed
countries resort to the World Bank to exert their influence on
underdeveloped countries. Also, various conditions are imposed on them
while giving loans.
The followin g international organizations are included under the World
Bank.
1. International Bank for Reconstruction and Development (IBRD)
2. International Development Association (IDA)
3. International Financial Corporation (IFC)
4. Multilateral Investment Guar antee Agency (MIGA)
5. International Centre for Settlement of Investment Disputes (ICSID)
The World Bank is referred to as the International Bank for
Reconstruction and Development (IBRD) and the International
Development Association (IDA). Today the Worl d Bank has 185
members.
7.3.1 Role Of World Bank :
The main objective of the establishment of the World Bank is to help
underdeveloped countries to achieve economic development, reduce munotes.in

Page 81

88 International Economics
88 poverty, stimulate economic growth through investment. The following
role of the World Bank as a development agency is important.
1. Economic & Social Development:
The World Bank is very useful as a financial source. The World Bank
plays an important role in reducing the problem of poverty and raising the
standard of living i n order to achieve sustainable and equitable growth in
underdeveloped countries.
Underdeveloped countries have always faced capital problems, so the
World Bank has been trying to encourage foreign investment. The role of
the World Bank in bringing about th e economic and social development of
underdeveloped countries is important because it provides all possible
help or cooperation to develop basic and infrastructural facilities in
underdeveloped or developing countries.
2. Efforts to reduce the problem of p overty (Poverty Reduction):
Most of the underdeveloped and developing countries are facing the
chronic problem of economic and social poverty. The World Bank
provides important support facilities to solve the problem of poverty in
underdeveloped countries. It provides capital to raise the income of the
lower and middle class people in such countries. Provides access to capital
for economic, social, financial, monetary and fiscal policies for sustainable
economic development. Poverty alleviation in underdeve loped countries is
one of the main objectives of the World Bank.
3. Supports debt relief:
Since the 1980s, the World Bank has focused and actively supported debt
relief as a solution to the international debt problem. The World Bank and
the International M onetary Fund (IMF) have launched the Heavily
Indebted Poor Countries (HIPC) since its inception. During 2002 -2026,
debtor countries will get relief from external debt problems. Such is the
expectation of HIPC .
4. Achievements of Millennium Development Goa l's - MDG's:
Today, the World Bank is focusing on the goals of happy -prosperous
development. 189 nations have signed up to this goal. It generally consists
of eight (8) major goals or objectives.
1. Poverty alleviation
2. Universal Primary Education
3. Equality and Women Empowerment
4. Reduce Child Mortality
5. Health improvement (Improve material health)
6. Malaria, H. I V. / Control of (AIDS). munotes.in

Page 82

89 International Economic Institutions 7. Ensuring sustainable environment
8. Development of Global Partnerships for Development
The World Bank a ims to meet or achieve the Sustainable Development
Goals by 2010. For this, the World Bank has sought further for the overall
development of underdeveloped countries.
A. Access to universal primary education.
b. H. i. Combating H.I.V. and AIDS.
c. Fundi ng of health programmes.
d. Conservation of Biodiversity
5. Fight Against Corruption:
Corruption is a growing problem in underdeveloped or developing
countries. The World Bank is playing an important role in fighting
corruption.
6. Assistance to conflict countries:
The World Bank is supporting 39 struggling countries. The World Bank
has implemented activities to provide education and training facilities to
these countries to stay away from conflict or war.
In short, the World Bank is playing a role for the economic, social,
cultural and political development of the underdeveloped countries, but
new challenges have arisen regarding the development of the developing
countries in the future. It is important that the World Bank's program
plans, activities are f or the economic development of the country
(sustainable) for poverty alleviation and human development.
Check your progress .
1. Briefly study the role of World Bank.
7.3.2 Functions of World Bank :
 The World Bank helps war -torn countries by provid ing loans for
reconstruction.
 They provide a wealth of experience and the financial resources of the
World Bank help poor countries to promote economic development,
reduce poverty and achieve better living standards. munotes.in

Page 83

90 International Economics
90  They help developing countries by provi ding development loans.
 The World Bank lends to various governments for irrigation,
agriculture, water supply, health and education.
 Encourages foreign investment in other institutions by guaranteeing
loans.
 The World Bank also provides economic, financial and technical
advice to member countries on all projects.
Thus, by introducing various economic reforms, we are promoting the
development of industries in developing countries.
7.4 WORLD TRADE ORGANIZATION (WTO) Setting up of World Trade Organisation (WTO ) in 1995, has been the
greatest event to occur, in recent times in international trade relations. The
purpose of WTO is to remove restrictions in international trade. It is
designed to play the role of a watch dog in the spheres of trade in goods,
trade i n services, foreign investment, intellectual property rights etc.
In the new era of globalization where the world economy is undergoing
significant changes, there is a need to study the impact of the WTO on the
Indian economy. We also need to review and e xamine the challenges that
the Indian economy will now be facing in the area of trade as a result of
the WTO agreements. Thus the setting up of WTO has thrown up number
of opportunities and challenges.
Formation of Wto : Gatt To Wto :
After the world war II , many countries got down together to work on ways
and means to promote international trade. The result was the signing of the
General Agreement on Tarrifs and Trade (GATT) by 23 countries in 1947.
India was one of the founder members of GATT. Over the yea rs the
membership of GATT has increased to 143 countries. GATT was
primarily concerned with the promotion of international trade through
tariff reductions, doing away with non discriminatory practices among
trading partners, and evolving rules to counter p rotectionism.
GATT provided for reduction in tariffs and trade restrictions in a phased
manner over a period of time. In all, Eight Rounds of Multilateral Trade
Negotiations were held under the auspices of GATT. The Eight Round
was held in Uruguay, in 1986 and in known as ‗Uruguay Round‘ This
Round took more than Eight years of complex negotiations. The final act
was signed in April 1994 by the member nations of GATT and this paved
the way for the setting up of WTO. The WTO agreement was singed by
104 membe r nations GATT and it came into force from January 1, 1995.
Thus, WTO was set up on January 1, 1995. The former GATT was not
really an organization. It was merely a legal arrangement on the other
hand, the WTO is a new international organization set up as a permanent
body and is designed to play the role of a watch dog in the spheres of trade munotes.in

Page 84

91 International Economic Institutions in goods, trade in services, foreign investment, intellectual property rights
etc. India is one of the founder -member of WTO. China and Taiwan
entered the world trade body towards the end of 2001. The present
membership of WTO is 149 countries.
Organization:
In WTO framework Ministerial Conference is the highest decision making
body, which has to meet at least once in two years. Following Ministerial
Conferences have b een held; so far viz. Singapore (9 – 13 December
1996), Geneva (18 – 20 May, 1998), Seattle (30 Nov. – 3 Dec., 1999) ;
Doha (9 – 14 Nov. 2001); Cancun (10 – 14 Sept. 2003); Hong Kong (13 –
18 Dec. 2005). The seventh WTO Ministerial meeting was held in Gene va
from Nov 30 – Dec. 3, 2009. In addition to the Ministerial Conference
there is a General Council again Consisting of representatives of all the
members. It itself meets as the Disputes Settlements Body (DSB) and the
trade policy review committee. There are three separate councils under
General Council : Council for Trade in Goods; Council for trade in
services, council for Trade Related Aspects of Intellectual Property
Rights.
7.4.1 Objectives of World Trade Organization (Wto) :
The main advantages of WTO can be stated as follows.
i) Removal of tariff and non -tariff barriers to trade.
ii) Abolition of discriminatory policies in international trade relations. In
relation to the trade sector, raising the standard of living of the people
in the country, inc reasing the employment level, increasing the real
income, increasing the effective demand, increasing the production,
increasing the trade in goods and services.
iv) Maximize use of global resources while promoting sustainable
development and economic grow th.
v) To increase the trade of developing countries by keeping a positive
attitude towards their economic development.
vi) Coordination and promotion of trade under multilateral agreements.
vii) Coordinating trade policies for transformational strategies and
sustainable development.
7.4.2 Functions of World Trade Organization (Wto) :
i) WTO is expected to promote international trade, for this it must
provided necessary administrative frame work.
ii) WTO should provide forum for negotiations among its me mbers.
iii) WTO should formulate rules of the trade and proper mechanism for
the settlement of disputes. munotes.in

Page 85

92 International Economics
92 iv) WTO should take periodical review of its trade policy.
v) WTO should work in co -operation with the IMF and the world bank.
vi) It administe rs the 29 Agreements contained in the final act of the
Uruguay Round of World trade.
vii) It oversees implementation of tariff cuts and reduction of non tariff
measures agreed to in the negotiations.
viii) It assists developing countries in implementin g Uruguay agreements
through a Developments Division.
7.4.3 Agreements of World Trade Organization (Wto) :
The World Trade Organisation (WTO) was set up in 1995 as the watchdog
for ensuring the free flow of trade among nations. India is one of the
founder m embers of the WTO and played a vital role in the multilateral
trade negotiations. Initially, the WTO was to confine itself to the
regulation of trade in goods. As these negotiations known as Uruguay
Round progressed, the developed countries succeeded in br inging in a
number of issues that are not directly related to trade in goods under the
gamut of the WTO. Important among these are the Trade Related Aspects
of Intellectual Property Rights (TRIPs), Trade Related Investment
Measures (TRIMs) and the General Agreement on Trade in Services
(GATS). These three agreements are since considered to be more
detrimental to the national interests of the developing countries than the
tariff and non -tariff barriers that these countries had to face. The benefits
of lowere d tariff rates were more than offset by these agreements. We
shall examine them in detail.
The main WTO agreements can be divided into the following categories.
7.4.3.1 Trips :
Intellectual property is considered as the corner stone for the progress of
deve loped countries. It refers to the creation and use of knowledge. In
simple terms, it refers to the protection that is accorded to the creators of
knowledge. Under the TRIPs Agreement, it is proposed that Member
countries should grant protection to the pate nts obtained by individuals
and organisations from the other member countries. Thus, a firm can claim
a patent in the USA and this protection is accorded to it in all the member
countries of the WTO. An important aspect of the new regime proposed
under the TRIPs agreement is that a patent is a product patent. That is
protection is given to entire product. Apart from patents, the protection is
given in the form of ‘exclusive market rights’ also. Under this, a firm can
obtain license as the sole supplier of a designated product in a particular
market/country. No other firm would be allowed to enter in to this market.
It is argued that these protections would encourage innovation and
technological progress. However, over the years, a number of issues
emerged th at showed the iniquitous nature of this agreement. We shall
now examine some of them. munotes.in

Page 86

93 International Economic Institutions 1. Protection of the intellectual property goes against the spirit of free
trade. Most of the patents are claimed by the multi -national
corporations (MNCs) operating from th e USA and Europe. In case of
pharmaceutical sector, the prices of medicines with patents and
exclusive market rights, the prices are much higher than in countries
with no such protection. This causes the exploitation of the consumer.
It is interesting to n ote that the USA has been a vocal supporter of
these measures. When some countries like South Africa and Brazil
proposed to waive off the protection on some of the life saving drugs
for HIV/AIDS treatment, the US opposed it claiming the ‘national
emergency ’ clause cannot be invoked by a member country.
However, in wake of the terrorist attacks on the USA, the anthrax
medicines were required on a large scale. Novartis Company had the
exclusive market rights for this product in the USA. When it was
found that the medicines provided by Novartis are three to four times
higher than those supplied by companies in the developing countries
like India, the US proposed to waive the protection accorded to
Novartis. Thus, the USA, who champions the cause of free trade, is
more opportunistic than the others are. The Supreme Courts of Brazil,
South Africa and others, that the national government alone has the
authority to declare a situation as a national emergency and no
international agreement can absolve a country of th is right have ruled
it.
2. The introduction of product patents led to a situation where the
domestic pharmaceutical industries have to face a survival problem.
The production of generic drugs has been an important source of
innovation that contributed to lowe r prices and expansion of firms.
The introduction of product patents in India in 2005 created a number
of problems.
3. The patent regime, created a situation where traditional knowledge
also could be exploited by profit -seeking MNCs. In case of many
Latin Ame rican countries, this has happened. In case of India, the
introduction of a particular variety of rice, termed as “Texamati”
created a furore. Similarly, attempts to seek patents on turmeric and
neem products also demonstrated the dangers of the TRIPs
agreements.
4. The TRIPS agreement provides for protection of traditional
knowledge from being patented. This includes plant varieties also.
The country has to declare a list of such items that are termed as
‘traditional’. In many developing countries, including India, precious
little is being done in this direction and thus, the MNCs can easily
claim protection on them.
5. Patenting of plant varieties will lead to serious problems in the
developing countries. Providing seeds at reasonable prices is a task of
all the national governments. If patents are granted to the profit -driven
MNCs on plants, the farmers would be left with nothing for survival.
An undeniable right of the farmers has been to use the produce of a munotes.in

Page 87

94 International Economics
94 year as seeds for the next. It is observed that in c ase of certain seeds
supplied by the MNCs, this is not possible. In other words, the farmer
cannot use his produce as seeds and has to return to the same MNC
each year for seeds.
6. The patenting of microorganisms is a further cause of concern. These
are used extensively in agriculture, pharmaceuticals and
biotechnology. In the coming years, these technologies would hold
the key for increased production and efficiency. Once the MNCs
obtain the protection, these benefits would be denied to a vast
majority of po pulation in the developing countries.
7. Most importantly, the developing countries are helpless victims of the
new global trade regime imposed by the developed countries at the
behest of the MNCs, which provide funds to these governments. The
WTO provides fo r a dispute settlement mechanism. Experience
however, shows that in many cases, the developing countries are
forced to suffer the losses than to challenge the will of the advanced
countries.
Thus, it is reasonable to conclude that the TRIPs agreement confe rred
undue advantages to the rich nations at the cost of the developing
countries.
Check Your Progress:
1. What are the main provisions of the TRIPs?
7.4.3.2 Trims :
The Agreement on Trade Related Investment Measures (TRIMs) relates to
the restricti ons on foreign investment, domestic regulations of industrial
activity and the incentives accorded to the domestic industries. ‘The
national treatment clause’ allows for non -discrimination between a
domestic and a foreign firm in access to the markets in a member country.
On the face of it, this agreement looks innocuous. However, the actual
implications have disastrous consequences. Let us now examine them in
detail.
1. An important provision for the development of domestic industries
has been the local conte nt requirements. Under this provision, each
foreign firm when enters into a country is required to obtain a certain
percentage of its value added from the domestic suppliers. This
arrangement was historically used by all the present day developed
countries , including the USA. However, under the new WTO regime,
this benefit is denied to the developing countries. All the local content munotes.in

Page 88

95 International Economic Institutions requirements are declared as invalid. This has adversely effected the
development of industrial sector in the developing count ries,
including India.
2. Providing subsidised capital for industries of national importance has
also been an important measure at promoting economic development.
However, the TRIMs do not allow such provisions. In one case, the
EU approached the WTO Dispute Settlement Board seeking to revoke
the interest subsidies to iron and steel industry in India. Since India
did not have a balance of payments problem, the DSB ruled that India
should stop these subsidies.
3. The TRIMs do not allow the host country to select t he industries in
which it would like to attract foreign capital. Thus, under this regime,
only profit seeking capital would be flowing into the developing
countries. The increase in investments by many luxury foreign brands
in India after 1991 is an indica tion of the adverse consequences of
TRIMs. The EU countries have been demanding the liberalisation of
wine/liquor investments in India. Profits, rather than public welfare
are the guiding force of capitalist investment.
Check Your Progress:
1. What is TR IMs?
7.4.3.3 GATS :
According to the IMF, trade in services refer to ‘economic output of
intangible commodities that may be produced, transferred and consumed
at the same time.’ There are three important components of trade in
services:
a. Transport: This covers all transport services provided by residents of
one economy for those of other and involve transport of passengers,
goods and so on. Insurance freight is not included here.
b. Travel: This covers goods and services acquired form an economy by
travellers in that economy for their own use during visits of less than
one-year duration for business and personal purposes. This includes
meals, lodging, and transport.
c. Other commercial services: These include activities like insurance and
financial services , international telecommunications, and postal and
courier services, computer data, news related service transactions
between residents and non -residents, construction services, royalties munotes.in

Page 89

96 International Economics
96 and license fees, miscellaneous business, professional and technical
services, and personal, cultural, and recreational services.
The GATS encompasses all that is traded under the four modes of service
transactions carried out among different countries: i) cross -border trade
(Mode 1); ii) consumption abroad (Mode 2); iii) Commercial presence
(Mode 3); and iv) movement of natural persons (Mode 4). It proposes to
bring in more transparency in the trade of these services and to provide a
level -playing field for all members.
Indian commitments at the GATS cover 33 activities li ke business
services; communications; construction work for civil engineering;
financial services; health -related and social services; tourism among
others. These commitments have sectoral variations in terms of free access
to Foreign Service providers. It also committed on market access and
national treatment clauses on sectoral restrictions in services. India did not
undertake any commitments in services relating to distribution, education,
environment, recreation, culture and sports; transport; and other services.
It has made specific MFN exemptions and further reserves the right to
liberalise to some WTO members in the areas of communications,
recreational and transport services. Further India is a member of the 43
country Information Technology Agreemen t (ITA) covering computers,
telecommunication equipment, semiconductors, manufacturing equipment
for semiconductors, software and scientific equipment. As a part of its
commitments under GATS, India adopted zero tariff on 217 information
technology related tariff lines.
The significance of GATS can be understood when one observes that
studies pointed out that the inefficient service sector raises the
manufacturing costs substantially for the industrial sector. In case of India,
it is estimated that in elect rical machinery, steel and ferrous alloys,
fertilizers and woollen textiles, the inefficient services are responsible for
manufacturing costs being higher by 25 percent and above.
India undertook gradual liberalisation of the FDI norms in many services
in light of these commitments. Since it has substantial presence in the
software sector, it needs to undertake some reciprocal liberalisation.
However, it is pointed out that India opted for its short -term interests at the
Hong Kong Ministerial and thus gaine d at the cost of its leadership of the
Third World Countries.
The US stand on H1B visas also is a case of inability to bargain for the
advantage of the country. In many cases, India failed to ascertain its
advantages and adopted a rather cautious stand on the liberalisation of
services.
Check Your Progress:
1. What do you understand by GATS? munotes.in

Page 90

97 International Economic Institutions
7.4.3.4 AOA :
This provides a frame work for the long term reform of agricultural trade
and domestic policies over the years to come, with the objective of
introducing increased market orientation in agricultural trade. It provides
for commitments in the area of market access, domestic support and
export competition. The members have to transform their non -tariff
barriers like quotas into equivalent tariff mea sures. The tariffs resulting
form this transformation, as well as other tariffs on agricultural products,
are to be reduced on an average by 36 percent in the case of developed
countries and 24 percent in the case of developing countries. The least
develop ed countries were not required to make any commitment for
reduction.
7.5 SUMMARY WTO was set up in 1995 with the aim of removing restrictions or barrier
from international trade. It is designed to play the role of a watchdog in
the sphere of trade in good s, trade in service, foreign investment,
intellectual property rights, etc. The government of India has made
commitments to WTO in the following fields (i) tariff lines (ii)
quantitative restrictions (iii) TRIPS (iv) TRIMS and (v) General
Agreements on Tra de in services (GATS). The benefits that India might
derive from WTO are (i) when world trade expands, India‘s trade will also
increase (ii) Phasing out of Multiple Fabric Agreement by 2005 will
benefit India as the export of textiles and clothing will inc reases (iii)
Prospects for agricultural exports will increase (iv) Multilateral rules and
disciplines will create a more favourable environment for trade. At the
same time India will have to make some homework at domestic level to
reap the benefits of thes e arrangements, such as developments of
infrastructure, making exports more competitive improve labour laws
check environmental degradation etc.
7.6 QUESTIONS 1. Discuss the objectives and functions of WTO.
2. Bring out the impact of WTO on Indian Economy.
3. Explain the WTO Agreements with respect is the following:
(a) TRIPs (b) TRIMs (c) GATS
***** munotes.in

Page 91

98 8
ECONOMIC INTEGRATION
Unit Structure
8.0 Objectives
8.1 Introduction
8.2 Objectives of Economic Integration
8.3 Forms of Economic Integration
8.4 Cartels
8.5 Trade Blocs
8.6 ASEAN
8.7 European Union (EU)
8.8 NAFTA
8.9 SAARC
8.10 Summary
8.11 Questions
8.0 OBJECTIVES  To know the meaning, objectives and forms of economic integration.
 To know about the ASEAN, EU, NAFTA and SAARC.
 To understand the concepts Cartels & Trade Blocs.
8.1 INTRODUCTION To know economic integration it is de sirable to know economic
liberalization. Economic liberalization is a process whereby structural
reforms are initiated in the economy. Economic liberalization involves the
following major changes: -
i) Changes in the outlook
ii) Technological up gradati on
iii) Changes in trade, fiscal, monetary, price and industrial policies
iv) Opening the economy for foreign investment
v) Delicensing and enhancing export incentives.
Economic liberalization attempts to remove restrictions and make an
economy glob al in its approach. Economic liberalization and globalization
go hand in hand. Economic liberalization facilitates global integration of
open economies. munotes.in

Page 92

99 International Economic Institutions After Second World War, countries of the world followed the policy of
protection so as to rehabilitate the war shattered economies. But it led to
adoption of a retaliatory policy on the part of other countries of the world.
It is called as the policy of tit for tat which led to the lowering down of the
volume of trade, lowering down of competitiveness, eff iciency, income
and employment. Hence all these things triggered off the wave for speedy
liberalization by reducing tariff barriers. It paved the way for economic
integration among the countries of the region and also among the countries
of the world. When economic integration takes place among the regional
economic integration. On the other hand when economic integration takes
place among the countries of the world it gets referred to as multilateral
economic integration. E.U, NAFTA, ASEAN, OPEC, SAARC are some
of the glaring examples of regional economic examples while GATT
which later on got merged into WTO are the glaring examples of
multilateral economic integration. A very important point to be noted in
connection with economic integration is that econ omic integration entails
some extent of political integration too if not full political integration.
Concept:
The Term economic integration has been interpreted in different ways.
Some authors even include social and political integration in economic
integration.
As per some authors the mere existence of trade relations between two or
more independent national economies signifies economic integration.
As per some authors economic integration is a type of an arrangement
which leads to removal of artifici al trade barriers for example tariffs
between two or more independent economies.
Economic integration is a general term which covers several kinds of
arrangements by means of which two or more independent economies
agree to come closer economically. By ec onomically integrating
themselves in the form of a union they would like to discriminate against
goods produced by countries of the rest of the world lying outside the
economic union.
As per Timbergen ―economic integration is the creation of most desirabl e
structure of international economy removing artificial barriers to the
optimum operation and introducing deliberately all desirable elements of
coordination or unification.
While defining the term economic integration he draws a distinction
between two t ypes of economic integration viz. positive and negative
economic integration. Positive economic integration refers to bring about
reforms in the existing institutional arrangement, checking out the neo
policy to correct the market imperfections. On the oth er hand the negative
economic integration refers to removal of artificial barriers like tariffs on
the movement of goods among the member countries of the group. munotes.in

Page 93

100 International Economics
100 Mr. Balasa defines economic integration as, ―a process and as a state of
affairs. As a proces s it encompasses measures designed to abolish
discrimination between economic units belonging to different national
states; viewed as a state of affairs, it can be represented by the absence of
various forms of discrimination between national economies.
While interpreting the term ―economic integration he draws a distinction
between economic integration and economic co -operation. The nature of
the difference is both quantitative and qualitative. Co -operation entails
action leading to lessen the severity of discrimination while economic
integration is a process which leads to adoption of measures which can be
used for the suppression of some form of discrimination. For example
G.A.T.T. or W.T.O. are the examples of cooperation. It is an agreement
between the member countries of the world about the trade policies to be
pursued in order to intensity the volume of trade among the member
countries of the world while removal of trade barriers the tariffs and other
non-tariff barrier is an example of economic integ ration.
The integration of economies resulted in the formation of various group of
nations for mutual cooperation in trade and service areas. They are termed
as “Trade Blocs”. Number of trade blocs have been formed worldwide
region - wise. In this chapter w e are concentrating on the evaluation and
functions of few blocs like NAFTA, EU, OPEC and SAARC. The large
scale and production is the outcome of such blocs and it is the step
towards good cooperation among the neighbouring countries.
8.2 OBJECTIVES OF EC ONOMIC INTEGRATION Economic integration or grouping are the formation of groups of friendly
nations for mutual benefits. Countries of specific region form their group
to enjoy common advantage of trade among themselves. Such integration
is known as Tradin g Blocs . Such grouping of nations started after the
second world war. Number of such blocs are active today at global level.
Both positive and negative advantages have been observed of such blocs.
One side they have increased trade and other side they also have created
imbalance in the world economy. It is because they have common
objectives for the member nations and for the non -members they have
discriminating restrictions. Some the important economic groupings or
trade blocs are EU, LAFTA, NAFTA, SAARC, ASEAN, OPEC, APEC
etc.
Objectives:
1. To eliminate or reduce trade barriers among the member countries of
the bloc to encourage free trade.
2. To promote growth and development of the all the members being
from the same region with mutual cooperation.
3. To provid e assistance to each other in case of emergencies or any
other socio -economic problems occurred. munotes.in

Page 94

101 International Economic Institutions 4. To bargain collectively with the non -members with unity against the
trade barriers and.
5. To make factor of production mobile within the group so that labour,
capital , and technology can be transferred easily within the member
countries.
6. To strengthen economic, social, political and cultural relations among
the members.
7. To make bloc strong and known through collective efforts including
mass production, large mark eting of goods and free movement of
capital and labour.
8.3 FORMS OF ECONOMIC INTEGRATION There are as many as five major types or forms of economic integration
which are as follows: -
i) A group of countries making preferential Trading Agreements.
ii) F.T.A i.e. Free Trade Area.
iii) C. U. i.e. Customs Union.
iv) C. M. i.e. Common Market
v) E. U. i.e. Economic Union
i) A group of countries making Preferential Trading agreements:
In this type of economic integration a group of countries come toge ther
and make tentative or temporary preferential trading agreements among
themselves to give preferential treatment to each other‘s goods. This is a
loose type of economic integration because this type of integration
remains temporary. The member countrie s of this group reduce tariffs on
imports of goods from each other while there is no change in the original
tariff policy followed by each member country of the group trading with
rest of the countries of the world which are not the members of the group.
For example common -wealth Preferential System of 1932. Great Britain
and the member countries of commonwealth established among
themselves a system of trade which was referred to as commonwealth
Preference System. As per this system the commonwealth countri es
reduced tariffs among themselves but allowed their high tariff rates to
continue on the imports from rest of the world countries.
ii) F.T.A. i.e. Free Trade Area:
As per the title a group of countries forming a free trade area bring about a
free trad e between them by removing all the trading restrictions. They
completely remove all tariffs on imports of goods from the member
countries. However, each member country of the free trade area retains its
autonomy in levying tariffs on the imports from non m ember countries of munotes.in

Page 95

102 International Economics
102 the world. The European Free Trade Area (EFTA) is a burning example of
Free Trade Area.
iii) C. U. i.e. Customs Union:
A customs Union is a free trade area plus a common policy of tariffs
adopted by the member countries in dealing with the imports from the non
member countries of the world. A burning example of customs union is E.
C. ie the European Community. It was formed in 1958 by signing the
treaty of Rome in 1957. By July 1, 1958 a customs union was established
among the original six members of the European Economic Community
viz Belgium, France, Federal Republic of Germany, Italy, Luxembourg
and Netherlands.
iv) Common Market:
A common market is a step higher than the customs union. A common
market is a customs union plus free m ovement of factors of production viz
labor and capital within the common market area or region. A common
market retains the two common character features of a customs union viz.
i) free trade among member countries by removing tariffs internally and ii)
the member countries follow the common tariff policy in dealing with non
member countries of the world.
A glaring example of common market is European Economic Community
which is also called as European Common Market which was established
in Jan. 1958 by si gning the treaty of Rome in 1957. It had original six
members viz Belgium, France, Federal Republic of Germany, Italy,
Luxembourg and Netherlands.
The treaty of Rome required every member to.
i) Eliminate tariffs, quotas and other barriers on intra -comm unity trade.
ii) Devise a common internal tariff on their imports from countries
belonging to rest of the world.
iii) Allow free movement of factors of production within the EEC.
iv) Harmonies their taxation and monetary policies and social security
policies and
v) Adopt a common policy on agriculture, transport and competition in
industry.
The EEC was expanded in 1973 with the inclusion of United Kingdom,
Denmark and Ireland. Greece joined the EEC in 1981. Spain and Portugal
joined the EEC on 1st Ja nuary 1986. Austria, Finland and Sweden joined
the EEC afterwards and as such the membership of EEC became 15.
The common market is an advanced stage of customs union. It provides a
free market for goods belonging to all the member countries. It facilitat es
the mobility of factors of production among the members of the
community. It means factors of production viz labour, capital and munotes.in

Page 96

103 International Economic Institutions enterprise can switch on to any member country to EEC which they can
find most profitable due to which efficiency and produc tivity increase.
v) E. U i.e. Economic Union:
The Economic Union is still an advanced stage of economic integration.
The Economic Union is a common market plus harmonization of national
economic policies viz monetary and fiscal policies.
An economic uni on can be defined as an economic integration which leads
to monetary union. The member of the economic union chalk out common
rules embodying things like taxation, economic legislation foreign trade,
agriculture, transport balance of payments, fiscal and m onetary policies,
social and economic welfare etc.
The glaring example of economic union is E. U. ie European Union viz
Benelux ie Belgium, Netherlands and Luxembourg.
vi) ECM or EEC i.e. European common market or European
Economic Community :
An economic union is a case of absolute economic integration. It means it
is a complete economic integration of group of countries.
Check Your Progress:
1. What do you understand by Economic Integration?
2. Give the reasons of popularity of Economic Integ ration.
3. What are the different types of Economic Integration? munotes.in

Page 97

104 International Economics
104
8.4 CARTELS An international cartel is formed by producers in the same line of
production in two or more countries, agreeing to regulate production and
sales for monopolist ic ends. Haberler defines international cartels more
precisely as “A union of producers in a given branch of industry, of as
many countries as possible, into an organisation to exercise a single
planned control over production and price and possibly to div ide markets
between the different producing countries.”
Concept of Cartel:
Business Agreement whether formal or informal that serve to limit or
suppress competition are referred to as cartel. Cartels originally developed
to suppress competitions from abro ad.
Formal or informal agreements among business enterprises engaged in the
same trade but located in different countries to limit competition to
regulate markets and restrict trade are known as international cartels.
Thus international cartels are a sor t of monopoly combines to eliminate
competition in the foreign markets. Cartel members usually form an
organised association through explicit agreements which would ensure
them higher profits than would be possible otherwise.
Conditions conducive to Intern ational Cartels:
Numbers of conditions led to the cartelization, which are as follows:
 When the number of producing firms is small.
 When the firms belonging to given industry have already reached
cartel agreements between different countries.
 When the process of manufacture or fabricated products can be
patented, iv) When there is a natural scarcity of raw material and
 When there is Government cooperation or leadership in the
organization of Cartel.
Indeed, the scope of cartels is wide eno ugh covering metals and minerals,
and manufactured goods like chemicals, dyestuffs, pharmaceutical
products and electrical goods. The main inducing factor behind the
formation of cartels is the fear of cut -throat competition and desire for
monopoly control . Further, when productive capacity is found to exceed
current demand, international cartels have been formed as an attempt to
share a diminished market. Professor Krause points out the following
important objects of cartels: munotes.in

Page 98

105 International Economic Institutions 1) To achieve control over pr ices Cartels resort to price -fixing above
.competition price and reap high monopoly profits.
2) To impair the quality of product. When cartels are formed, buyers will
have no safeguards against low quality, since hardly an opportunity is
made available t o the buyers to choose between different varieties.
3) To make allocation of trade territories and thereby to acquire and
maintain a monopolistic position by each cartel member in their
respective allocatedmarkets.
4) To restrict supply, assigning quotas to each cartel member.
5) To deliberately retard technological change until the existing plants
and productive facilities have been fully depreciated.
Merits of cartels:
1) Due to business combines, large -scale output is made possible, so
goods may be sold at cheaper rates through cartels.
2) Cartels tend to eliminate wasteful competition also.
3) Cartels can solve the problem of excess capacity.
Drawbacks of cartels:
1) They tend to reduce international trade on account of restricted output
and hi gh price policy.
2) International cartels may also mean under -utilization of the world‘s
resources and manpower, in view of lack of competition and the
system of production quotas followed by the cartel members.
Since international cartels are not govern ed by impartial international
machinery in favor of the consumer‘s interest in general, it is utmost
desirable that cartels must be prevented by all means. For breaking up the
cartels, it is necessary to adopt unilateral action through anti -thrust
measures by a country, coordinated with such international actions.
8.5 TRADE BLOCS A Trade block is a cluster of nations meant for regionalism. It is a free
trade area which removes all the obstacles to trade (tariffs and non tariffs)
among themselves. It is a c ustom union which not only removes obstacles
to intra -regional trade but also follows a common trade policy towards rest
of the world countries ie with the non member countries. In case of a
regional trading block like common market there is not only a fre e
movement of goods and services but also a free movement of factors of
production regionally. In case of a perfect trading block like economic
union there is a retention of all the feature of the previous types of regional
trading blocks plus there is a h armonization of national economic policies
viz. monetary and fiscal policies. The economic union may switch over to munotes.in

Page 99

106 International Economics
106 have its own common currency such that regional trading block can also
be called as common currency block.
We are going to study the five m ain types of regional trading blocks which
are as follows: -
(i) E. U. i.e. ECONOMIC UNION
(ii) NAFTA i.e. NORTH AMERICAN FREE TRADE AGREEMENT
(iii) APEC i.e. ASIA -PACIFIC ECONOMIC CO -OPERATION
(iv) ASEAN i.e. ASSOCIATION OF SOUTH EAST ASIAN NATIONS
(v) SAARC i.e. SOUTH ASIAN ASSOCIATION FOR REGIONAL CO -
OPERATION
8.6 ASEAN ASEAN stands for Association of South East Asian Nations. The origin of
ASEAN goes back to ASA. ASA stands for Association of Southeast
Asia. It was proposed by Mr. Tunku Abdul Rahman, the Prime Minister of
Malaya in 1959. The member countries of ASA fought among themselves
due to political and territorial disputes as a result of which ASA couldn‘t
last long. On 8th August 1967 a declaration was signed by Five south East
Asian co untries viz. Indonesia, Malaysia, Philippines, Singapore, Thailand
as per which the Association of South East Asian Nations (ASEAN) was
formed to accelerate the economic growth of the member countries with
the spirit of equality and partnership. Brunei and Vietnam joined ASEAN
in 1984 and 1995 respectively. Burma and Laos joined ASEAN in 1997.
United States of America supported the establishment of ASEAN. The
establishment of ASEAN shows a move towards globalization.
ASEAN nations area of land and the popul ation are larger than European
union comprising of 15 nations. The outstanding feature of the economic
growth strategy of ASEAN is FDI i.e. Foreign Direct Investment. Foreign
trade in the life blood of ASEAN. The economic prosperity and the
economic integr ation of ASEAN depend upon two important factors viz.
controlling inflation and sustained high growth rate. As regards natural
resources ASEAN is a treasure island. The aim of ASEAN is to become a
Free Trade Area by reducing tariffs among the ASEAN. Inspit e of
tremendous political, economic and cultural diversity the ASEAN
countries are becoming integrated.
8.7 EUROPEAN UNION (EU) Economic Union (E.U.) is also known by several other names viz. E.E.C.
which stands for European Economic Community.
E.C.M. wh ich stands for European Common Market.
E.C. which stands for European Community munotes.in

Page 100

107 International Economic Institutions The origin of Economic Union goes back to the signing of the treaty of
Paris in April 1941 by Germany, Italy and Netherlands leading to the
setting up of the European Coal and Steel Community (ECSC) Afterwards
Europe made a comprehensive attempt in the realm of economic
integration in forming the European Economic Community (EEC) on 1st
January 1958 by signing the treaty of Rome on March 24, 1957 by six
Western European countri es known as ―Inner Sixǁ viz. France, Germany,
Italy, Belgium, Netherlands and Luxemburg.
The immediate objective behind the establishment of EEC was to set up a
custom union. A custom union is one which removes the tariff barriers
within the regional tradi ng block and follows a common tariff policy in
trading with the non -member countries. Later on the custom union was
transformed into a common market in which not only goods and services
but also factors of production like labour, capital, enterprise are fr ee to
move within the regional trading block. Later on the EEC as a common
Market got transformed into economic Union which led to harmonization
of laws, social policy, economic, monetary, fiscal policies, international
trade policies etc.
The following ar e the provisions of the treaty of Rome:
Article 2
i) The community shall have a common market
ii) A harmonious development of economic activities within the region.
iii) Balanced expansion of the region increase in stability, increase in the
standard of living of the people of the region and the closer
relationship between the countries belonging to the region.
Article 3
i) Elimination of custom duties and qualitative restrictions on the import
and export of goods
ii) The establishment of common com mercial policy towards other
countries (non member countries)
iii) The abolition of all obstacles to freedom of movement for persons,
services and capital.
iv) The adoption of common policy of Agriculture.
v) The adoption of common policy of transportati on.
vi) To ensure that competition in the common market is not distorted.
vii) To coordinate the economic policies of the members of the region and
disequilibrium in the balance of payments should be corrected.
viii) The laws of the member countries of the region should be adjusted as
required for the proper functioning of the Common Market. munotes.in

Page 101

108 International Economics
108 ix) Improvement in employment opportunities and raising of the standard
of living.
x) The establishment of European Investment Bank to facilitate the
economic expansi on of the EEC through creation of fresh resources.
xi) To promote economic and social development of the member
countries of EEC.
The membership of the EEC is open to all the European countries. It rose
from the original Six to Nine in 1973 when Denmark, Ireland and United
Kingdom joined the community. In 1981 the membership of EEC rose to
ten when Greece joined the community. Portugal and Spain joined the
community in 1986 and the membership of the EEC rose to twelve. In
1995 three more countries viz. Aus tria, Sweden and Finland joined the
EEC and thus the total membership of the community rose to fifteen.
In 1992 a Treaty of Maastricht was signed which strengthen the process of
integration by creating a common currency w. e. f. Jan. 1999. It led to
making the price system and the exchange rate system more stabilized.
The Economic Union has built up an institutional system which is unique
in the world. Following are some of the most important institutions: -
i) The Council of European Union:
It is a main dec ision making body of The Economic Union. It is a cluster
of ministers from each member country of the union.
ii) European Parliament:
It is a cluster of elected members from each member country. It
supervises the European Commission. It also shares the legislature and
budgetary powers with the council of the E.U.
iii) European Commission:
It is a conglomeration of the commissioners nominated by the member
countries of the E.U. It is the main administrative body of E.U. which is
responsible for day to d ay administration of E.U.
iv) Court of Justice:
It is the highest legal authority of E. U. Each country nominates one judge
to the court of Justice of E.U.
v) European Central Bank:
It is a central monetary authority of E. U. It issues Euro notes and coin s. It
is a foreign exchange authority of E.U.
vi) Court of Auditors:
It‘s main function as a court of Auditors is to cheque EU‘s revenue and
expenditure. munotes.in

Page 102

109 International Economic Institutions vii) Economic and Social Committee:
It is an authority on economic and social policy of E.U.
viii) European Committee of Regions:
The portfolio of this committee is to maintain the rules, regulations and
identities to the respective regions. It is composed of representatives from
all the states of the region.
ix) European Investment Bank:
It is the financ ial Institution of E.U.
x) European Ombudsman:
It is an official appointed by E.U. to investigate people‘s complaints
against public organizations.
The European Union is not against globalization. It‘s exports and
investments are of very high order. The Eu ropean Union contributes 1/4th
of the total worlds exports which accounts for about 15% of its GDP. As
much as 40% of the foreign direct investment (FDI) of the developed
countries goes to the European Union
8.8 NAFTA NAFTA stands for NORTH AMERICAN FREE TRADE AGREEMENT.
NAFTA is an extension of CUSTA i.e. the Canada United states Trade
Agreement. Though United States of America supported the move to form
the regional trading groups like EEC but it was suspicious about its
working. Therefore in 1965 the un ited states of America and Canada
entered into bilateral trade agreement to eliminate tariffs on automobiles
and auto -parts. In 1985 both the countries decided to integrate their
economies generally by reducing trade barriers like tariffs gradually over a
period of ten years. In 1989, USA and Canada formed a Free Trade Area
and hence along with goods trade in services among them was also
liberalized. It was also decided that other internal problems like subsidies,
dumping and other trade policy should be se ttled peacefully and friendly.
However they couldn‘t set up customs union as it was difficult to have a
common tariff policy with rest of the world countries or with non member
countries. Canada joined hands with America in forming Free Trade
Union because it faced with the disadvantageous situation due to
following of the policy of protection on the part of U.S.A. The United
States of America also wanted to see that Mexico also should join the
agreement and ultimately in December 1992, the three countries signed
the agreement leading to the formation of the North American Free Trade
Agreement (NAFTA). The operation of NAFTA commenced from
January 1994.
As per the provision of NAFTA all tariffs and quotas on manufactured and
agricultural goods are to be elim inated within 5 to 15 years. It is called as
a transitional period. Restrictions on direct foreign investment (DFI) munotes.in

Page 103

110 International Economics
110 between the NAFTA members will be lifted. The Intellectual Property
Rights (IPRs) are to be protected in the member countries i.e. in the
NAFTA viz. U.S.A. Canada and Mexico. It is expected that Chile and
other Latin American countries may join NAFTA in future. It was decided
that trade in financial services will be liberalized by 2000.
Check Your Progress:
1. What do you mean by Regional tr ade blocks?
2. Explain the working of European Union.
3. What do you understand by NAFTA?
8.9 SOUTH ASIAN ASSOCIATION FOR REGIONAL CO-OPERATION (SAARC) The abbreviation, SAARC stands for The South Asian Association for
Regional cooperation. The move to have an economic regional block
among south Asian countries started taking shape from 1980. The first
summit of seven south Asian countries viz. India, Pakistan, Bangladesh,
Nepal, Shri Lanka, Bhutan and Maldives took place at Dha ka in December
1985 and the SAARC came into existence. The idea behind the formation
of SAARC was to have fearless tensionless progress and prosperity in the
South Asian Association for Regional cooperation regional group
countries. The SAARC emerged out o f the problems faced by South Asian munotes.in

Page 104

111 International Economic Institutions countries. The SAARC has got over 1/5th of world‘s population. It has
only 3.3% of world‘s total land area. It has a major share of total world‘s
poor population. These countries can be branded as a low per capital
incom e countries. India is the largest SAARC country having 2/3rd of
SAARC population while Maldives is the smallest island having
population of only 3 lakhs.
Following are some of the most pressing problems faced by SAARC
countries:
i) The very first problem faced by the SAARC countries is the Border
dispute problem, political problem and the religious problem.
ii) The economies of all the seven member countries of SAARC are
more or less similar. Dissimilar economies call for economic
integration.
iii) Negl ect of intra -regional trade. Their exports are channelised towards
hard currency area.
iv) Most of the SAARC member countries are exporting almost the same
types of products. For example India and Shri Lanka export tea.
v) The economic strength of the me mber countries of SAARC is
different so is the case with economic development. Hence benefits
accrue more to the relative economically stronger countries than the
relative economically poor countries was the feeling developed
amongst the SAARC countries.
vi) The main hurdle in the way of intra -regional trade is the scarcity of
foreign exchange.
vii) These countries also face number of inadequacies like transportation,
communication etc.
The main objectives of SAARC:
Following are the main objectives of S AARC as per Article 1 (One) of the
charter of
SAARC: -
i) To promote the welfare of the people of South Asia and to improve
their standard of life.
ii) To accelerate economic growth, social progress and cultural
development in the region and to provide al l individuals the
opportunity to live in dignity and to realize their full potentials.
iii) To promote and strengthen collective self -reliance among the member
countries of SAARC.
iv) To contribute to mutual trust, understanding and appreciation of each
others problems. munotes.in

Page 105

112 International Economics
112 v) To promote active collaboration and mutual assistance in the
economic, social, cultural, technical and scientific fields.
vi) To strengthen cooperation among themselves on matters of common
interest.
vii) To strengthen cooperation amon g other developing countries.
viii) To co -operate with international and regional organizations with
similar aims and purposes.
Principles:
Following are the principles laid down as per Article II of the charter of
the SAARC: -
i) Co-operation within the framework of the Association shall be based
on respect for the principles of sovereign equality, territorial integrity,
political independence, non -interference in the internal affairs of other
countries and mutual benefit.
ii) Such co -operation shall not be a substitute for bilateral and
multilateral co -operation but shall be complementary.
iii) Such cooperation shall not be inconsistent with bilatera l and
multilateral obligations.
The SAARC countries started with cooperation in non -economic areas
like sp orts, arts, culture etc. Later on they switched over to the following
area: Agriculture, Rural development, Telecommunication, Science of
technology, Health Transport, Post etc.
In 1991 6th SAARC Summit was held at Colombo in which the idea of
Preferential Trading Arrangement popularly known as SAPTA was
piloted. On 11th April, 1993 7th SAAR Summit was held at Dhaka. The
basic principles of are as follows: -
i) Overall mutual advantages.
ii) Step by step extension of preferential trade arrangements.
iii) Inclusion of all types of products – raw, semi finished and finished
iv) Special and favorable treatment to LDCs ie Less Developed
Countries.
The SAARC Preferential Trading Arrangement (SAPTA) is to play a very
important role in stepping up the intra -regional trade. All the SAARC
countries have been implementing the proposal of reduction in tariffs and
they have also undertaken economic policy reforms.
SAARC Preferential Trading Agreement (SAPTA):
SAPTA came into operation from December 7, 1995. It he ralds a new
chapter of economic co -operation among the original seven member munotes.in

Page 106

113 International Economic Institutions countries of SAARC -India, Pakistan, Bangladesh, Sri Lanka, Nepal,
Bhutan and Maldives, Afghanistan became its eighth member in early
2007. It also concretise the first step toward s creation of a trade bloc in the
South Asian Region.
Under the SAPTA mechanism, the SAARC countries have identified 226
items for exchange on tariff concessions ranging from 10 per cent to 100
per cent. India has agreed to extend tariff concessions on 106 items, while
Bangladesh has agreed to offer tariff concession on 12 items, Maldives on
17, Nepal 14, Pakistan 35, Sri Lanka 31 and Bhutan 11. Out of 106 items
offered by India for tariff concessions, 62 items would be for the least
developed countries in the SAARC.
SAPTA to SAFTA: SAPTA has paved way for the setting up of the South
Asia Free Trade Area(SAFTA), which came into force from July 1, 2006.
The developing countries have been given a span of seven years, and the
least developed countries have been provided a span of ten years for its
full implementation.
The South Asian developed countries are well endowed with labour and
natural resources. Growing openness among themselves would lead to
higher production and expansion of labour -intensive exports, thus
increasing employment, increased wages and thereby helping in reducing
poverty .
Role of India:
India plays a dominant role in SAARC because of its commanding
position in SAARC. Demographically India is the most popular country
among the SAARC coun tries. It possess the largest land area and
economically also it commands relatively a better position. Though India
itself suffers from several problems still there is a scope for India to play
its dominant role in SAARC from both the sides ie from the si de of
rendering helping hand to member countries of SAARC to tide over their
problems and from the side of demanding help from the member countries
of SAARC in terms of piloting the scheme of joint ventures specially in
the fields of Co -operation, Agricult ure, industry, energy, transport,
tourism, business, communication, widening of markets etc. The second
SAARC summit was held in India at Bangalore in 1986.
8.10 SUMMARY  Economic integration means group of nations from the similar regions
agreed for mutua l trade and development.
 It is also known as Trading Blocs
 It is advantageous for the growth and development of all member
nations agreed with each other on many issues.
 Economic integration among the world economies varies in degree.
They are FTA, CU,CM and ECU. munotes.in

Page 107

114 International Economics
114  Only EU has been successful in achieving highest degree of economic
forms or types.
 NAFTA is ex pected to eliminate all tariffs Non -Barriers among USA,
Canada and Mexico. It is the leading bloc and has large dealings and
contribution in world trade.
 European Union has been the most successful bloc. It has maximum
members dealing in free trade. It has its own common currency being
used by all the members for promoting quick and fast trade.
 SAARC is the developing bloc. Its members are all the developing
nations and it is the world’s consuming bloc having maximum
population. It is the poorest bloc havin g number of socio -economic
turmoil’s.
 SAPTA has been trying to assist the poorest nations of SAARC for
trade development.
 ASEAN countries have close cohesiveness, share their economic and
human resources and achieve synergy in the development of
agricultu ral sector, industrial sector and service sector.
8.11 QUESTIONS 1. What is Economic Integration and what are its objectives?
2. Explain the forms/ Types/ Degrees of Economic Integration?
3. Write a note on –
a) Cartels
b) Trade Blocs
c) ASEAN
d) European Union (EU)
e) NAFTA
f) SAARC

*****



munotes.in

Page 108

Question Paper Pattern (For IDOL Students Only)
TYB A SE M V I (Economics) – for all Six papers


Time: Three Hours Total Marks: 100 Marks

Please Check whether you have got the right question paper.
N.B. 1) All questions are compulsory. Attempt Sub question (A) or (B) of Question no. 5
2) Figures to the right indicate marks.
3) Draw neat diagrams wherever necessary.


Q1. Answer any TWO questions of the following. 20
Mar
a.
b.
c.

Q2. Answer any TWO questions of the following. 20
a.
b.
c.

Q3. Answer any TWO questions of the following. 20
a.
b.
c.

Q4. Answer any TWO questions of the following. 20
a.
b.
c.

Q5. (A) Write short notes on any TWO of the following. 20
a.
b.
c.
d.
OR
(B) Multiple choice questions, select an appropriate option (20 MCQs) 20

munotes.in