Dr. Shabeer K P: April 2020

UGC NET-JRF ECONOMICS

INTERNATIONAL ECONOMICS

Theories of International Trade

q Mercantilist Views on Trade

q Absolute Advantage Theory

q Comparative advantage Theory

q Opportunity Cost Theory

q Modern Theory of International Trade

Mercantilist Views on Trade

n Collection of economic thought in Europe during 1500 to 1750

n Merchants, bankers, philosophers

n National wealth is reflected in holdings of precious metals

n More gold, more powerful the country (Bullionism)

n Export more as it leads to inflow of gold

n Restrict import as it leads to outflow of gold

n Govt should do everything possible to maximise exports and minimise imports

n Trade is a “Zero- Sum Game”

n One Country could gain only at the expense of others

n One’s Gain is loss of other

n Mutually beneficial trade is impossible

n Calls for ‘economic nationalism’

n Nation could regulate its domestic and international affairs to promote its own interests

n Emergence Neo mercantilism

n Nations seeks to restrict imports in an effort to stimulate domestic production and employment

Absolute Advantage Theory-Adam Smith

n Refuted mercantilist views on trade

n Mutually beneficial trade is possible based on ‘absolute advantage’

n Each country should specialise on the basis of absolute advantage and exchange for other commodities

n Specialisation leads to increased world production

n Benefits of increases world production reaches all countries

n Trade is a “positive-sum game”

n All participating countries gain from trade

n Advocated ‘laissez-faire’

Labour Theory of Value

Comparative Advantage Theory-David Ricardo

Ø Still unchallenged law in Economics

Ø “Principles of Political Economy and Taxation” (1817)

Ø Tried to explore unanswered question in Smithian Absolute Advantage

Ø Why would trade occur if one country is more productive than other country in all lines of production ?

n Mutually beneficial trade is still possible if less efficient country is not equally less productive in all lines of production

n Less efficient country Should specialise where its disadvantage is smaller, that is, on the basis of comparative advantage

Assumptions

n 2x2 Model: 2 Countries (England and Portugal), 2 Commodities (Wine and Cloth)

n Labour is the only factor of production which is homogenous and its supply remains unchanged

n Labour theory of value

n Factors are immobile across countries

n Law of constant returns with given technological knowledge

n Free trade and no transportation cost

n Full employment

Opportunity Cost Theory: Haberler

Ø Explained theory of comparative advantage based on opportunity cost (1936)

Ø “Law of comparative cost”

Ø Opportunity cost of a commodity is the amount of second commodity that must be given-up to release just enough resources to produce one additional unit of first commodity

Ø Country with a lower opportunity cost in production of a commodity has a comparative advantage in that commodity and comparative disadvantage in the second commodity

Modern Theory of International Trade

1. The Heckscher Ohlin Model

2. Factor Price Equalisation Theorem

Modern Theory of International Trade: Heckscher Ohlin Model

Eli Heckscher (1919): Effects of Foreign Trade on Distribution of Income
Bertil Ohlin(1933): Interregional and International Trade

Analysed reasons for comparative advantage

n Basis for comparative advantage is comparative cost difference

n Reasons for comparative cost difference is due to :-

1) Countries differ in their factor endowments

2) Commodities differ in their factor intensities

Assumptions

Ø 2x2x2 Model :2 Countries (I & II),2 factors (K & L), 2 Commodities (X & Y)

Ø Perfect competition

Ø Factors are immobile across countries

Ø Full employment

Ø Same technology

Ø Constant returns to scale

Ø Free trade

Ø Inter-industry trade

n Factor Intensity

Ø Measured Using Capital-labour Ratio (K/L)

Ø Y is assumed to capital intensive and X is labour intensive

q Factor Abundance

Ø Defined in relative terms

Ø Physical definition (T_K/T_L) and the price definition (P_K/P_L)

Ø Country II is assumed to be capital abundant country in terms of both definitions

Fundamental Theorem

“each country should specialise in the production and export of those goods whose production requires a relatively large amount of the factor with which the country is relatively well endowed”

n Capital abundant country will tend to specialise in capital intensive goods

n Labour abundant country will tend to specialise in labour intensive goods

n Abundance of factor makes it cheap (less expensive)

n Producers prefers less expensive factor

n Capital rich country tend to specialise in capital intensive goods

n Labour rich country tend to specialise in labour intensive goods

Leontief Paradox

n Empirical Tests or Exceptions of Heckscher Ohlin Model – Leontief Paradox

n First comprehensive empirical test of H O

n Used US trade data of 1947

n US was believed to be a K rich L scarce country

n If H O is true , then US should export K intensive good and import L intensive goods

n Leontief used Input-output technology

n Startling result !

n US were exporting labour intensive products and importing capital intensive products

n Opposite of Heckscher Ohlin prediction

n Paradoxical result termed as ‘Leontief paradox’

Leontief’s Own explanation for the paradox?

1) US labour is three times more productive than labour of the rest of the world

2) Tastes of US citizens biased highly in favour of capital intensive goods

n Other Explanations for Leontief Paradox

1947 was too close to the World War II to be representative
Used a two factor model (labour and capital) thus abstracting from other factors
Distortions of the trade pattern caused by tariffs may have influenced the results
Included only physical capital in his measure of capital and ignored human capital

Empirical Tests or Exceptions of Heckscher Ohlin Model – Factor Intensity Reversal

Ø In H O model pattern of trade is determined by factor intensity and factor endowments

Ø Changes in these two is possible overtime

Ø Such changes could reverse the pattern of trade

Ø Factor intensity reversal is when one commodity is capital intensive in capital abundant country and labour intensive in labour abundant country

Ø Each country will specialise in the same product

Ø H O theorem becomes invalid

ü Takes place when production isoquants cut each other more than once

Factor Price Equalisation Theorem Samuelson

n Corollary of Heckscher Ohlin Theorem

n Sometimes referred to as Heckscher- Ohlin- Samuelson theorem

n Free international trade equalizes factor prices between countries relatively and absolutely

n International trade serves as substitute for the international mobility of factors.

ü International trade causes ‘w’ to rise in low-wage country and fall in high-wage country

ü International trade reduces the pre-trade difference in ‘w’ between two countries

ü International trade causes ‘r’ to fall in capital-expensive country and to rise in capital-cheap country

ü Reducing the pre-trade difference in ‘r’ between the two countries

International Trade under Imperfect Competition

n Traditional theory of international trade has assumed that commodities being traded were homogeneous or identical

n it assumed that all international trade is inter-industry trade meaning that countries trade different goods with one another

n But a characteristic of a country’s trade that has appeared in many new theories and is increasingly recognised as important in the real world is intra industry trade

n Intra industry trade occurs when a ‘country is both exporting and importing items in the same product classification category’

n Traditional trade theory dealt only with inter industry trade, but intra industry trade constitutes an important segment of international trade

International Trade under Imperfect Competition :Concept of Intra industry trade

Reasons for Intra industry trade

Economies of scale
Product differentiation

Measurement of Intra industry trade

Measured by the intra industry trade index (T), which is

T= 1 – X – M

X + M (0 < T < 1)

X and M represents the value of exports and imports of a particular industry or commodity group.
T=0 when a country only exports and only imports the good in question (there is no intra industry trade)
T=1, when exports and imports of a good are equal (intra industry trade is maximum)
Developed by Bela Balassa

Brander Krugman Model

Ø James Brander (1981): “Intra Industry Trade in Identical Commodities”

Ø Brander and Paul Krugman (1983): “A Reciprocal Dumping Model of International Trade”

Ø Popular model of intra industry trade dealing with oligopoly market

Ø Reciprocal dumping model

Ø Explains international trade of identical or homogeneous commodity

Ø 2x2 model (two countries and two firms)

Ø Both firms producing homogeneous product with same marginal cost

Ø Presence of transport cost makes the market separated (barrier)

Ø Monopoly Markets

Ø If TC is not very high, monopoly becomes duopoly

Ø Situation in which dumping leads to two way trade in the same product is termed as reciprocal dumping

Ø Two firms of two countries resort to dumping in each others domestic market

Ø Price decreases but uncertainty prevails

n Trade Based on Technological Differences

1. Technological Gap Model

2. Product Cycle Theory

Technological Gap Model

n Michael V Posner 1961

n also called “imitation lag hypothesis”

n relaxes the assumption in the H-O analysis that the same technology is available everywhere

n It assumes that the same technology is not always available in all countries

n There is a ‘delay in the transmission of technology’ from one country to another

n A great deal of trade among industrialized countries is based on introduction of new products and new production process which give innovating firm and country a temporary monopoly in the world market

n “imitation lag” is defined as the length of time that takes between product’s introduction in country I and the appearance of the version produced by firms in country II

n Central point of importance is that trade focuses on new products

n A country can become a continually successful exporter by focusing on continuous innovation

Product Cycle Theory

n Reymond Vernon 1966

n Generalization and extension of the Technological Gap Model

n Builds on its treatment of delay in the diffusion of technology

n When a new product is introduced, it requires highly skilled labour

n As the product matures and acquires mass acceptance, it becomes standardized and familiar so that it can be produced with less skilled labour

n Comparative advantage in the product shift from the advanced nation that originally introduced it to LDCs, where labour is relatively cheaper

New Product Stage
Product Growth Stage
Product Maturity Stage
Product Decline Stage
Product Decline Stage

n Stresses the standardization process

n Most highly indutrialised economies are expected to export the non-standardised products embodying new and more advanced technology and import products embodying less advanced technology

n Through imitation and product standardization, LDCs earn a comparative advantage based on their relatively cheap labour

Terms of Trade

n Crucial determinant of the distribution of gains from trade

n Measure to evaluate the gains to individual countries from international trade

n Measures the relationship between prices a country gets for its exports and prices that it pays for its imports

n It is the relative price at which two countries trade

1) Commodity Terms of Trade or Net Barter terms of Trade

2) Gross Barter terms of Trade

3) Income terms of Trade

4) Single factoral terms of Trade

5) Double factoral Terms of Trade

n Commodity terms of trade (or barter terms of trade) is the most frequently used measure of the direction of trade gains

n It is the ratio of price index of export to price index of imports

ToT = export price index x 100

import price index

Terms of Trade = P_X x 100

P_M

n Taussing

n Gross barter terms of trade is the ratio between the index of physical quantity of a country’s import and export

Gross barter ToT = quantities of import

quantities of export

• A rise in GBToT is regarded as favorable as more imports are received by given volume of exports

Ø Jacob Viner

n Take into account productivity changes in both domestic export sector and the foreign export sector producing the country’s import

Theory of Reciprocal Demand

J S Mill (1848): Principles of Political Economy
Introduced reciprocal demand to determine the equilibrium terms of trade
Indicate “the country’s demand for one commodity in terms of the quantities of the other commodity it is prepared to give up in exchange”

Assumptions

2x2 Model: 2 countries (England and Germany) and 2 commodities (Linen and Cloth)
Law of constant returns
Free trade with no transportation cost
Perfect competition
Full employment
Principle of comparative cost is applicable in trade relations between two countries

n Terms of trade between two countries will lie between 1 linen or I cloth or 1.33 of cloth

n Actual ratio depends on reciprocal demand

n If Germany’s demand for England cloth is inelastic, then terms of trade will be nearer to 1:1, favourable to England

n If Germany’s demand for England cloth is more elastic, then terms of trade will be nearer to 1:1.33, favourable to Germany

Offer Curve

n Also called reciprocal demand curve

n devised and introduced to by Alfred Marshall and Edgeworth

n indicates the quantity of imports and exports the country is willing to buy and sell in world markets at all possible relative prices

n shows country’s willingness to trade at various possible terms of trade

n directly shows the trade flows that correspond to any given relative price

n offer curve is a combination of a demand curve (demand for imports) and a supply curve (supply of exports)

n In one axis it show country’s exports and on the other its imports

n It is the locus of various combinations of two commodities which a country finds acceptable for trade

n tries to show how the terms of trade are determined by the interactions of demand and supply

n resolve the problem of determining the exact terms of trade that emerge in trade equilibrium

n Bulges towards the axis where country’s exportable good is measured

n based on the principle of diminishing marginal utility of imports

Economic Growth and International Trade

Country grows if ‘its PPC moves outwards’

Two sources

Increase in the endowment of one or more factors
Improvement of technology

Growth of factors of Production

n labour and capital grows at the same rate, the country’s PPC will shift out evenly in all directions at the rate of factor growth

n PPC will shift out in an equi-proportional manner. This is the case of balanced growth or factor neutral effect

n If only one factor grows, the PPC shift outward asymmetrically in the direction of the commodity intensive to accumulating factor

Rybczynski Theorem

n British economist T M Rybczynski 1955

n Analysed sources of growth in increase in the endowment of one of the factors of production

“Growth of one factor leads to an absolute expansion in the output of the commodity that uses that factor intensively and absolute contraction in the output of the commodity that uses the other factor intensively”

if the endowment of one of the factor of production increases, the endowment of other being constant, the output of the commodity using accumulating factor intensively will increase and the output of other commodity decrease in absolute terms, provided that commodity and factor prices are kept constant

Technical Progress and International Trade

n important element in modern economic life

n empirical studies have indicated that most of the increase in real per capita income in industrial countries is due to technical progress and much less to capital accumulation

n John Hicks have classified technical progress into neutral, labour-saving and capital-saving

Effects of Growth on Trade

n both factor growth and technical progress results in an outward shift in the country’s PPC

n What happens to the volume of trade depends on the rate at which the output of the country’s exportable and an importable commodity grow and on the consumption pattern of the country

Production and consumption can be

Pro-trade
Anti-trade
Neutral

Secular Deterioration Hypotheses

n Also referred to as the Singer-Prebisch hypothesis because of its popularization by the two UN economists, Raul Prebisch and Hans W Singer (1950s)

n Refers to the argument that, over a span of several decades or so, there has been a persistent tendency for the commodity terms of trade to fall for developing countries

n Third world primary-products exporting countries are experiencing secular (long run) deterioration in terms of trade

n Commodity terms of trade have been improving for industrialised countries

n LDCs had to export increasing amounts of their primary products in exchange for imports of manufactured goods from industrially advanced countries

n The international economy is transferring real income from less developed countries to indutrialised countries

n The secular deterioration in terms of trade was considered as one of the important reasons for LDCs economic backwardness

Three main reasons for the deterioration of terms of trade of LDCs

Differences in income elasticities of Demand
Unequal market power
Technological change

n Primary product exporting countries were not gaining from expanding their agricultural and mineral exports

n The policy recommendation is that LDCs should concentrate more resources on expanding their modern industry and fewer resources on expanding output and exports in their primary sectors

Theory of Immiserising Growth

n Jagadish N Bhagawati 1958

n Expressed serious doubts regarding the possible benefits of international trade and international trade as a substitute for economic growth

n Under certain circumstances, economic expansion and trade may harm countries, especially developing countries

Ø Refers to a case where economic growth (due to technical progress and/or factor accumulation) leads to sufficiently acute deterioration in the terms of trade which imposes a loss of real income outweighing the primary gain in real income due to growth itself

n Economic growth, at times, may cause so severe deterioration in the country’s terms of trade that the gains from growth in output could be more than offset by a loss from adverse terms of trade

n The country winds up with a lower level of economic welfare after growth

Two basic factors

Economic growth primarily increases the capacity and output in the export sector of the country’s economy. That is, country’s growth is biased towards its export sector
World demand for the export product of the country suffers from very low elasticities

n Apply to all primary producing and exporting countries because many agricultural commodities suffer from very low world demand elasticities

n Possibility of immiserising growth underlines the drawbacks of export-expanding growth by the way of worsening of the terms of trade

The Dutch Disease

n Developing a new exportable resource can cause problems in some countries

n Dutch disease is such a problem perceived by Netherlands following the development of new natural gas fields under North Sea

n situation was emerged when the industrially rich Netherlands began to exploit its domestic natural resource that it previously imported

n The exchange rate appreciated so much as to cause country to lose international competitiveness

n faced the impending danger of de-industrialisation

n The Netherlands was sitting on a huge quantity of oil and gas reserves in 1970s

n one would have expected the Dutch to perform the best in such a scenario

n But, quite opposite happened.

n International investors made a beeline for Dutch assets. The price of these assets rose appreciating the Dutch currency

n Appreciation made the production of traded goods unprofitable and unemployment rose in the country.

n perceived strength of Dutch economy caused financial outflows which squeezed the traded goods sector and caused unemployment

n name derived from the Netherlands’s loss of relative competitiveness in its traditional industrial sector as a result of the appreciation of the Dutch currency after the development of Dutch natural gas industry

Foreign Trade Multiplier

n Also called export multiplier

n Multiplier in an open economy

K^l= 1

MPS+MPM

n Reciprocal of the sum of marginal propensities of save and import

n Smaller is the leakages greater the value of K^l

Protection

v Policy whereby domestic industries are protected from foreign competition

Arguments for Protection

Infant industry argument (Hamilton 1791)
Terms of Trade argument
Anti dumping argument
Balance of trade argument
National defense argument
Key industries arguments
Employment argument

n Forms of Protection

(1) Tariff

(2) Non Tariff Barriers

Forms of Protection- Tariff

n Most important form of protection

n Tax or levy or duty on traded commodity as it crosses national boundaries

n Price based measure (import tariff and export tariff)

Types

Specific tariff
Advelorem tariff
Compound tariff

Effects of Tariff

Price Effect
Consumption Effect
Production Effect
Revenue Effect
Balance of Trade Effect
Welfare Effect

Optimum Tariff

n Rate that maximizes country’s welfare

n Starting from a free trade position increase in tariff leads to increase in welfare up to maximum (optimum tariff), then welfare decreases as tariff is again raised

Stolper Samuelson Theorem

n Wolfgang Stolper & Samuelson (1941)

n Income effect of tariff and later income effect of international trade

“an increase in the relative price of a commodity (for example, as a result of tariff) raises the return or earnings of the factor used intensively in the production of the commodity”

n Thus, the real return of the country’s scarce factor of production will rise with the imposition of tariff

Ø International trade will reduce the income of the abundant factor of production and increase the income of the scarce factor of production with in a country

Ø International trade enhances country’s total welfare, but the gains from trade are not necessarily equally distributed among the factors of production

Ø The income of the scarce factor may be growing faster overtime

Exception to Stolper Samuelson Theorem- Metzler Paradox

n Discovered by Metzler in 1949

n The unusual case where a tariff lowers than raises the relative price of the importable commodity to individuals in the country

n Then the income of the scarce factor also falls

n The Stolper-Samuelson theorem no longer holds

n Non Tariff Barriers to Trade

Quotas
Voluntary Export Restraints
Technical, administrative & other regulations
Export Subsidies
Dumping
International cartel

International Monetary System

Ø Refers to rules custom, instruments, facilities and Organizations for affecting international payments

Classified on the basis of

a) How exchange rates are determined?

b) What form the international reserve asset take?

Exchange Rate Classification

1) Fixed Exchange Rate System

2) Adjustable Peg Exchange Rate System

3) Crawling Peg Exchange Rate System

4) Managed Floating (dirty float)

5) Freely Floating (clean float)

International Reserve Classification

1) Gold Standard

2) Pure Fiduciary Standard

3) Gold Exchange Standard

Gold Standard(1880-1914)

n First and oldest system

n Fixed exchange rates

n Each country defines gold content of its currency and ready to buy any amount of gold at that price

n Mint Parity

n Willingness to back currencies with gold

n Currencies are freely convertible in to gold

Ø Gold can be bought and sold at will

Ø No restriction on the shipment of gold

Ø Collapsed with the outbreak of First World War (1914-18)

Ø Tried again after the war but failed with Great Depression (1929-33)

Brettonwoods Conference (1944)

v 44 countries of United Nations met at Brettonwood, New Hampshire US

v Aim was to create a new international monetary system

v To avoid instability and protective policies of Great Depression

v Called for the establishment of TWO Organisations

IMF, to achieve exchange rate stability and help countries to finance BoP deficits
IBRD, to assist post-war reconstruction and development of member countries and to provide long-term development assistance
ITO, to eliminate trade barriers (NEVER MATERIALISED)

n Gold exchange standard

n US to maintain the price of gold at $35 per ounce and ready to exchange $ for gold without restriction

n Other countries to fix exchange rate with $

n Pegged exchange rate system (+ 1%)

Problems of the system

Liquidity or adequacy of reserve problem
Confidence Problem
Adjustment Problem

Reasons for the collapse

Ø 1945-49 : Huge BoP surplus for US (Marshall Plan)

Ø 1950s : period of US BoP deficits

Ø $ shortage to $ glut

Ø Gold depletion of US

Ø Inability to devalue $ as intervention currency

Ø Nixon Shock : Richard Nixon (August 15, 1971) withdraw commitment of gold convertibility of $

Post Brettonwoods Era

Smithsonian Agreement (1971)

n After Nixon shock

n Meeting of leading industrial countries at Smithsonian Institute, Washington DC

n Established new set of par values called “central rates”

n Countries agreed to permit + 2.25 either side of the central rates

n Germen Mark and Japanese Yen was revalued by 13% and 17% respectively

n Provided greater exchange rate flexibility than Brettonwoods system (+ 1%)

n Created optimism for future

n Failed due to continuous speculations of $ and steps taken by countries to float their currencies

Jamaica Accords (1976)

n January 1976

n IMF made series of changes that were incorporated into IMF’s Articles of Agreement

Changes:-

Ø Each member country was free to adopt its own exchange rate arrangement

Ø Role of gold to be downgraded and SDR to be enhanced

Ø IMF to maintain surveillance of exchange rate behavior to avoid manipulation

Balance of Payment

“Statistical record of all international economic transactions of residents of country with residents of rest of the world during a year”

Ø Economic transaction:- exchange of good, service or asset for which payment is required

Ø Unilateral transfers (for which no payment is made) are also included in BoP

Most important statistical record of a country !

Ø Reveals export and import of goods and services

Ø Reveals borrowing and lending of the country

Ø Reveals foreign exchange position of the country

ü BoP are always in balance

ü Double entry book keeping system

ü Each transaction has a credit and equal debit side

Balance of Payment Accounts

Current Account
Capital Account
Other Remaining Items

Current Account

n Export and import of goods and services and unilateral transfers

n Sum of visible trade and ‘invisible balance’

n Invisible balance :-export and import of services, receipts of interest, dividends, profits and unilateral transfers

Merchandise Export and Import

n International trade of all tangible products send-out or brought-in

n Visible export and import

Service export and import

n Trade of services like tourism, banking, transportation, health, insurance and so on

n Invisible items

Capital Account

n Movement of financial capital in and out of the country

Ø Capital inflows: credit item; through borrowing, sales of overseas assets, investment by foreigners

Ø Capital outflows: debit item; through lending, buying of overseas asset, purchase of domestic asset owned by foreigners

Foreign Investment

Foreign Direct Investment (FDI)

Ø One that gives the investor a control over investment

Ø Control need not be 100%

Ø Business investments

Ø Faces market risk

Ø ‘Real’ investment

Ø Examples: purchase of a company abroad, starting a subsidiary or taking over the control of existing firm on other country

Foreign Portfolio Investment (FPI)

ü No control over investment

ü Lending of capital to get return but no control over the use of capital (rentier investment)

ü Financial investment

ü Indirect investment

ü Examples: investment in securities, deposits in commercial banks, purchase of equities, bonds, securities and so on

Other Remaining Items of BoP

Errors and Omissions: reflects difficulties of accurate information
Official Reserves and Liabilities : as balancing items; changes in Gold, SDRs and foreign currencies

Disequilibrium in International Transactions

n BoP are always in balance

n Each credit transaction in the account has a corresponding debit elsewhere

n Thus, only sub accounts of BoP can be in disequilibrium

Autonomous Items

Ø All the transactions in the current and capital account

Ø Purely done for profit or business motive

Ø Items above the line

Accommodating Items

v To finance any deficit or surplus in the autonomous receipt and payment

v Determined by the net consequences of autonomous items

v Balancing item

v Items below the line

Disequilibrium in International Transactions

Deficit or Surplus in Current Account
Basic Balance : sum of current account balance and net balance on long-term capital
Official Settlement Balance: operations of monetary authorities undertakes to finance any deficit in current account and/or capital account

1. Deficit or Surplus in the Current Account

n The trade account

n Provides information on changes in the economy since visible and invisible trade react quickly to changes in other economic variables

n Has an effect on the confidence in the foreign exchange market

n Has a knock-on effect on the economy

2. Basic Balance

n Defined as the sum of the current account balance and net balance on long-term capital

n Considered to be the best indicator of the country’s position vis-à-vis other countries during the period of fixed exchange rates in1950s and 1960s

n Having an overall basic balance deficit is not necessarily a bad thing !

3. Official Settlement Balance

n Focuses on the operations that the monetary authorities have to undertake to finance any imbalance in the current and capital account

n Is the settlement concept

n To be financed by the authorities drawing on their reserves of foreign currency, borrowing from the foreign monetary authorities or the IMF

Theories of Balance of Payments

1) Elasticity Approach of Balance of Payments

2) Absorption Approach of Balance of Payment

3) Monetary Approach to Balance of Payment

Elasticity Approach of Balance of Payment

n Marshall, Lerner, Robinson and Machlup

n Analyses effects of devaluation on current account

n Based on trade flows and depends on how “elastic” imports and exports are to exchange rate change

Two effects of Devaluation

Price effect:- X becomes cheaper and M becomes costlier… lead to worsening of BoT
Volume Effect:- volume of X will rise and M will fall….. Lead to improvement of BoT

n Elasticity Approach of Balance of Payment

Marshall Lerner Condition

dCA = M (ŋ_x + ŋ_m -1)

n Devaluation will improve current account if and only if ŋ_x + ŋ_m >1

(That is, the Sum of two elasticities is greater than unity)

The Absorption Approach of Balance of Payment

n Sidney Alexander 1952

n Income effect of devaluation

n More comprehensive analysis

n Reaction against restrictive assumption of elasticity approach

n Changes in export and import volume will effects national income

n Current account is viewed as difference between domestic output and domestic absorption (expenditure or spending)

CA=Y-(C+I+G)

CA= Y-A

dCA= dY-dA

Effects of devaluation on National Income

Increases production of export and import competitive goods
Leads to deterioration of ToT

Monetary Approach to BoP

n Robert Mundell and Harry Johnson (1960s and 1970s)

n Viewed BoP as a ‘monetary phenomenon’

n Money plays a crucial role

n Demand for money and supply of money

DD for money:- M_d = kPY

SS of Money :- M_s = m(D+F)

Exchange Rate determination

R = M_s/M_s*

kY/k*Y*

n Deficit in BoP due to excess SS of money leading to depreciation of currency

n Surplus in BoP due to excess DD for money leading to appreciation

J Curve Effect

n In short run devaluation leads to worsening of BoT

n Ultimately BoT improves

n Possibility that Marshall Lerner condition does not hold in the short run but will be holding in long run

n BoT deteriorates first, then improves

Currency Pass Through

Increase in the domestic price of the imported commodity may be smaller than the amount of depreciation, even after lags
Percentage by which import prices rises when the currency depreciates by one percentage is known as degree of “pass through” from the exchange rate to import prices

n Pass through from depreciation to domestic prices may be less than complete

Reasons

1) Foreign firms (exporters) will be reluctant to increase prices by the full amount of the depreciation

2) International market segmentation allows imperfectly competitive firm to charge different prices for the same product in different countries

Foreign Exchange Market

• Worldwide network of markets and institution that handle the exchange of foreign currencies

• Buying and selling of foreign currencies or foreign exchange

• Largest Market : London

• Heavily Traded Currency : US Dollar

Participants

1) Commercial Banks

2) Business Corporations

3) Non Bank Financial Institutions

4) Central Bank

Functions

Transfer of funds or purchasing power from currency to another or from one country to another
Credit function
Facilities for Hedging and Speculation

Exchange Rate

• Price of one currency in terms of other

• May be defined in one of the two ways

Cost in domestic currency of purchasing one unit of foreign currency. That is, domestic currency units per unit of foreign currency
Amount of foreign currency that may be bought for one unit of domestic currency. That is foreign currency units per unit of domestic currency

Exchange Rate

Nominal Exchange Rate
Real Exchange Rate
Effective Exchange Rate

Real Exchange Rate

Real exchange rate is the Nominal exchange rate adjusted for relative prices between countries under consideration
Expressed in index form
S is the nominal exchange rate expressed as foreign currency units per unit of domestic currency

Effective Exchange Rate

• Explores the exchange rate of one currency against a basket of currencies with whom the country trades

• Effective exchange rate is the weighted average of exchange rates between domestic currency and the country’s most important trade partners

• Weights are given by the relative importance of the country’s trade with each of the trade partners

• Measure of whether or not the currency is appreciating or depreciating against a weighted basket of currencies

Equilibrium Exchange Rate

• Determined just like the price of any commodity

• Determined by the interaction of the market demand curve for and market supply curve of the foreign currency

• Demand :-purchase goods and services, unilateral transfers, purchase of financial asset, making investments, to avoid losses and to make profit

• Supply:- foreigner’s purchasing home exports , unilateral transfers, foreign investment in the home country, purchase of home currency to avoid losses or to make profits

Exchange Rate Adjustment Policy

Fixed Exchange Rate

Ø Pegged Exchange Rate

Ø Each country fixes its exchange rates against currencies of other countries

Ø Monetary authorities intervene in the foreign exchange market constantly by buying and selling currencies to avoid any fluctuations of exchange rates

Ø No day-to-day fluctuations

Ø Small margins of fluctuations around a par value will be allowed

Flexible Exchange Rate

• Floating Exchange Rate

• Authorities do not intervene to buy or sell their currencies in the foreign exchange market

• Allow the value of their currency to change due to fluctuations in the supply and demand of the currency

• Exchange rates are completely free to vary and foreign exchange market is cleared at all times by changes in exchange rates and not by any buying and selling of currencies by the monetary authorities

Managed Floating

Controlled floating
Monetary authorities intervene to smooth out short run fluctuations in exchange rate
By supplying and purchasing currencies
Dirty float
Policy of leaning against the wind
If intervene frequently heavily will be called filthy float

Adjustable Peg System

• Exchange rate is pegged of fixed for a period of time

• Until the fundamental disequilibrium in BoP arise and forex reserves are exhausted

• If fundamental disequilibrium persists, currency is repegged at a lower or higher exchange rate

Crawling Peg System

Monetary authorities adjusts exchange rates gradually
Adjusts at regular intervals by small amounts instead of making large devaluation or revaluation
Also known as Trotting Peg or Gliding Parity System

Exchange Rate Band

• Currency is allowed to fluctuate between an upper and lower exchange rate

• Exchange rate is not allowed to move outside the band

• Band can be narrow or wide

• Monetary authorities intervenes only when exchange rate hits the ceiling of the and

• ‘Snake in the tunnel’ :- band within the band; EEC countries in 1972

Theories of Exchange Rate Determination

q Purchasing Power Parity Theory

q Monetary Approach of Exchange Rate Determination

q Asset market Model or Portfolio Balance Approach

Purchasing Power Parity Theory

• Considered as one of the earliest and simplest models of exchange rate determination

• Attributed to Swedish economist Gustav Cassell (1918)

• Intellectual origins dates back to the writings of the 20^th century British economist David Ricardo

• Rest on “the Law of One Price”

• States that “in the presence of competitive market structure and absence of transport cost and other barriers of trade, identical products which are sold in different markets will sell at the same price when expressed in terms of same currency”

• Based upon the idea of perfect good arbitrage

• Exchange rate must adjust to ensure that the law of one price

Absolute PPP Theory

• Strict interpretation of the law of one price

• the equilibrium exchange rate between two currencies is equal to the ratio of the price levels in the countries

S = P/P*

Relative PPP Theory

• can be expected to hold even in the presence of distortions of international trade.

• postulates that the change in the exchange rate over a period of time should be proportional to the relative change in the price levels in the two countries over the same time period.

• relates the change in exchange rate to change in price levels in the two countries

PPP Theory : Empirical Texts

ü works well and the law of one price hold in the case of highly traded individual commodities but less well for all traded commodities together and not so well for all commodities which include many non-traded commodities

ü works reasonably well over very long periods of time covering many decades

ü performs better for the countries that are geographically close to one another and where trade linkages are high

ü found that the exchange rates have been much more volatile than the corresponding national price level

PPP Theory : Criticisms

Assumptions underlying the law of one price do not hold
Problem of defining the common bundle of commodities
Presence of non-traded commodities

Monetary Approach of Exchange Rate Determination

• Robert Mundell and Harry Johnson

• PPP theory indicates that the exchange rates are closely related to the level of prices in different countries.

• But it does not explain what determines national price level or the rate at which it changes

• Monetarists believe that the money supply and its growth rate determine the price level and inflation rate.

• They suggests that money supplies in different countries, through their links to national price levels and inflation rates are closely linked to exchange rate in the long run

• Exchange rate is a monetary phenomenon

• Money plays the crucial role in the long run both as a disturbance and as an adjustment in the country’s exchange rate

• Based on three key assumptions

1) There is a stable money demand function

2) Prices are flexible and markets operate perfectly so that there is vertical aggregate supply schedule reflecting full employment

3) There is purchasing power parity theory so that exchange rate adjusts to the ratio of domestic prices level and foreign price level

• Exchange rate is determined by the relative supply and demand for the different national money stock

• An increase in the domestic money stock relative to the foreign money stock will lead to a rise in the exchange rate or depreciation of the home currency.

• An increase in the domestic income relative to the foreign income leads to a fall in exchange rate or appreciation of home currency

Asset Market Model or Portfolio Balance Approach

• Extends the monetary approach to include other financial assets besides money

• Developed since mid 1970s and there is extremely large number of asset market models in existence

• Pioneered by Wiiliam Brason (1976,1977,1984) and Pennti Kouri (1976) and has been subsequently modified by Maurice Obstfeld (1980), Girton and Henderson (1977) and Allen and Kenen (1980)

• Postulates that the exchange rate is determined in the process of equilibrating or balancing the stock or total demand and supply of financial assets in each country

• Regarded as a more realistic and satisfactory version of the monetary approach

• Emphasizes the role of portfolio repositioning by international financial investors

• Individuals and firms hold their financial wealth in some combination

Domestic money
Domestic bond
Foreign bond denominated in foreign currency

• Equilibrium in each financial market occurs when the quantity demanded of each financial asset equal its supply

• Investors hold diversified and balanced portfolios of financial assets

• This is why asset market model is also called portfolio balance approach

• Exchange rate is determined in the process of reaching equilibrium in each financial market

Demand for financial assets are influenced by

Domestic rate of interest (i)
Foreign rate of interest (i*)
Expected Appreciation of the foreign currency (EA)
Risk Premium (RP)
Real income or output (Y)
Domestic price level (P)
Wealth (W) of the country’s residents

Home individuals demand for domestic money

M = f ( i , i* , EA, RP, Y, P, W )

ü Positively related to the risk premium , the home country real income, prices and wealth

ü inversely related to the interest rate in the home country and foreign country and expected appreciation of foreign currency

Demand function for domestic bonds

D = f ( i , i* , EA, RP, Y, P, W )

ü positively related to i, RP and W

ü inversely related to i*, EA, Y and P

Demand function for the foreign bond is

F = f ( i , i* , EA, RP, Y, P, W )

ü positively related to i*, EA and W

ü F is inversely related to i, RP, Y and P

Ø All three assets are substitutes of each other and change in any variable will set in motion a whole host of adjustments on the part of investors

Ø Setting the demand for three assets equal to their respective supplies, which are assumed to be exogenous, one will get the equilibrium quantity of M, F and D

Ø Equilibrium values are obtained simultaneously

Ø Portfolio adjustments and exchange rates

Foreign Exchange Market

• Worldwide network of markets and institution that handle the exchange of foreign currencies

• Buying and selling of foreign currencies or foreign exchange

• Largest Market : London

• Heavily Traded Currency : US Dollar

Participants

1) Commercial Banks

2) Business Corporations

3) Non Bank Financial Institutions

4) Central Bank

Functions

Transfer of funds or purchasing power from currency to another or from one country to another
Credit function
Facilities for Hedging and Speculation

Exchange Rate

• Price of one currency in terms of other

• May be defined in one of the two ways

Cost in domestic currency of purchasing one unit of foreign currency. That is, domestic currency units per unit of foreign currency
Amount of foreign currency that may be bought for one unit of domestic currency. That is foreign currency units per unit of domestic currency

Exchange Rate

v Nominal Exchange Rate

v Real Exchange Rate

v Effective Exchange Rate

a) Nominal Effective Exchange Rate (NEER)

b) Real Effective Exchange Rate (REER)

Real Exchange Rate

Real exchange rate is the Nominal exchange rate adjusted for relative prices between countries under consideration
Expressed in index form
S is the nominal exchange rate expressed as foreign currency units per unit of domestic currency

Effective Exchange Rate

• Explores the exchange rate of one currency against a basket of currencies with whom the country trades

• Effective exchange rate is the weighted average of exchange rates between domestic currency and the country’s most important trade partners

• Weights are given by the relative importance of the country’s trade with each of the trade partners

• Measure of whether or not the currency is appreciating or depreciating against a weighted basket of currencies

(a) Nominal Effective Exchange Rate (NEER)

Unadjusted weighted average rate at which one currency is exchanged for a basket of currencies
Not adjusted for inflation
Indicator of country’s international competitiveness
Trade weighted currency index
Expresses how domestic currency’s value compares against multiple foreign currencies

(b) Real Effective Exchange Rate (REER)

Weighted average exchange rate of a country’s currency in relation to a basket of other currencies
Adjusted for inflation rate
Weights are determined by comparing relative importance in trade
REER is calculated on the basis of NEER
Captures the inflation differentials between countries

Equilibrium Exchange Rate

• Determined just like the price of any commodity

• Determined by the interaction of the market demand curve for and market supply curve of the foreign currency

• Demand :-purchase goods and services, unilateral transfers, purchase of financial asset, making investments, to avoid losses and to make profit

• Supply:- foreigner’s purchasing home exports , unilateral transfers, foreign investment in the home country, purchase of home currency to avoid losses or to make profits

Dealing Rates in Foreign Exchange Market

q Spot Exchange Rate

q Forward Exchange Rate

q Foreign Exchange futures

q Foreign Exchange Option

q Currency Swap

Spot Exchange Rate

Ø Quotation between two currencies for immediate delivery

Ø It is the current exchange rate of two currencies vis-à-vis each other

Ø The most common type of foreign transactions involving payment and receipt of the foreign exchange within two business days

Ø Exchange rate governing on the spot

Ø Type of transaction is called a spot transaction and the exchange rate at which the transaction takes place is called the spot rate

Forward Exchange Rate

Market where buyers and sellers agree to exchange currencies at some specified date in future
Involves an agreement today to buy or sell a specified amount of foreign currency at a specified future date at the rate agreed upon today
Typical forward contract is for one month (30 days), three months (90 days) or six months (180 days)
Contract amount is large( size of at least $ 5 million)

• At any point of time, the forward rate can be equal to, above or below the corresponding spot rate

• If the forward rate is below the present spot rate, the foreign currency is said to at a forward discount with respect to the domestic currency

• if the forward rate is above the present spot rate, the foreign currency is said to at a forward premium

Foreign Exchange Futures

Standardised forward contracts
agreement between two parties to exchange a standardised amount of two currencies at a given date in future at a predetermined exchange rate
Only 4 specific maturity dates (the third Wednesday of March, June, September and December
Usually for smaller amounts (around $ 50,000 - $ 100,000)

Foreign Exchange Futures

Traded only on exchange and few geographical locations such as London, Chicago, New York, Frankfurt and Singapore
Covers only major currencies
Contracts are guaranteed by the Exchange
Obligation can be easily sold onto a third party and thus have greater liquidity
Initial margin (money) is required

Foreign Exchange Option

Ø Contract that gives the purchaser the right, but not the obligation, to buy or sell a currency at a predetermined price (exchange rate) some time in future

Ø Currency in which the option is granted is known as the “underlying currency”. The currency to be exchanged for underlying currency is known as the “counter currency”

Ø Option contract involves two parties, “the writer”, who sells the option contract and “the holder” who purchases it

Call Option
Put Option

• If the option contract gives the holder the right to purchase the underlying currency at a predetermined from the other party, the contract is known as “call option”

• If it gives the owner the right to sell the underlying currency at a predetermined exchange rate to the other party, it is known as “put option”

• Price at which the underlying currency can be bought or sold is known as “strike price or exercise price”

• Date at which the contract expires is known as the “expiry date or maturity date”

• Price paid by the holder for the writer for an option is known as the “option fee or premium”

• This fee represents the maximum loss the holder would experience should the option not be exercised

Currency Swaps

• refers to a spot sale of a currency combined with a forward repurchase of the same currency as a part of a single transaction

• swap is a series of future exchange of amounts of one currency for amounts of another

• In a currency swap, principal amounts are exchanged at both the beginning and at the end of the swap. Thus, swap is a set of spot and forward exchanges packaged into one contract

• The advantages of currency swap over the package of separate foreign exchange contracts are (a) lower transaction cost by using one contract and (b)decrease in the risk exposure.

• Most of the inter-bank trading involving the purchase or sale of currencies for future delivery is not done by forward exchange contracts alone but combined with spot transactions in the form of currency swap

Foreign Exchange Risk

• Arises out of the fluctuations in the value of assets, liabilities, income or expenditure when unanticipated changes in the exchange rates occur

• When ever future payments must be made or received in foreign currency

• Due to ever-changing spot exchange rate

Types of Foreign Exchange Risk

Transaction Exposure: arises during transactions involving future payments and receipts in a foreign currency
Translation or Accounting Exposure: arisen when we value inventories and assets held abroad in terms of the domestic currency for inclusion in the firm’s consolidated balance sheet
Economic Exposure: arises when estimating the domestic currency value of the future profitability of the firm

Hedging

• Avoidance of foreign exchange risk

• Altering the composition of assets and liabilities so as to offset an existing or potential exposure of foreign exchange risk

• Want to eliminate or reduce risk exposure

• Usually takes place in the forward foreign exchange market

• Seeks to reduce or eliminate their risk exposure by hedging

• In a world of foreign exchange uncertainty, the ability of traders and investors to hedge greatly facilitates the international flow of trade and investment.

• Hedging permits exporters and importers to protect themselves against risks connected with exchange rate fluctuations and thus enabling them to concentrate on their pure trading functions

Speculation

• Opposite of hedging

• Accept or take risk in the hope of making profit

• Uncertain gain from unanticipated changes in the exchange rate

• Committing oneself to the uncertain future value

• Takes place in the forward market

• Stabilizing v/s destabilizing

• Stabilizing speculation refers to the purchase of a foreign currency when the exchange rate falls or is low in the expectation that it will soon rise

• Stabilizing speculation moderates the fluctuations in exchange rtes overtime and performs a useful function

• Destabilizing speculation refers to the sale of a foreign currency when exchange rate fall or purchase of a foreign currency when the exchange rate is rising or is high,

Arbitrage in Foreign Exchange Market

• Refers to the purchase of a currency in the monetary center where it is cheaper for immediate resale in the monetary center where it is more expensive in order to make profit

• In the process, price is driven up in the cheaper market and down in the expensive market

• As a result, the exchange rate between two currencies tends to be equalized in the two monetary centers

• Uniqueness of exchange rate regardless of geographical locations

• Because one is buying and selling currency simultaneously, there is no risk in this activity and hence there are always many potential arbitrageurs in the market

• arbitrage can be said as the exploitation of price differentials for risk less guaranteed profit

• Risk-less activity

Internal and External Balance

• internal balance = full employment for the labour force along with the stable level of prices

• External Balance= equilibrium in the Balance of payment

country have the following policy instruments at their disposal

1) Expenditure changing or demand policies

2) Expenditure switching policies

3) Direct controls

• Expenditure changing policies include fiscal and monetary policies. It refers to changes in fiscal and monetary policies which aim to influence the level of aggregate demand in the economy.

• Expenditure switching policies refers to changes in the exchange rate. That is, it refers to policies such as devaluation and revaluation of the exchange rate which attempt to influence the composition of spending between domestic and foreign goods.

• Direct controls consist of tariffs, quotas and other restrictions of international trade and capital.

• These are expenditure switching policies but they can be aimed at specific Balance of Payment items

• Direct controls in the form of price and wage controls can also be used to control domestic inflation when other policies fail

International Monetary Fund (IMF)

• Product of Brettonwood conference

• Began operations in Washington DC in March 1, 1947

• Started with 30 members, now has 189 members

• Website : www.imf.org

• International Monetary Fund (IMF)

• Head Quarters : Washington DC

• Present Managing Director : Kristalina Georgieva

• International Monetary Fund (IMF)

Objectives

To promote international monetary cooperation
To facilitate expansion and balanced growth of international trade
To promote exchange stability and maintain orderly exchange agreements
Provide borrowing facilities for countries in temporary BoP difficulties

Functions

Surveillance
Financial Assistance
Technical Assistance

Borrowing from IMF

• Each country assigned a quota

• Quota is based on economic importance and volume of international trade

• Size of quota determines voting power and ability to borrow

• US assigned largest quota followed by Japan, China, Germany and France (India’s position = 8^th )

Country pay 25% of quota in gold and 75% in own currency (Gold Tranche and Credit Tranche)
Paying 25% of quota in gold was discontinued in 1978 and replaced by SDR
Country can borrow 25% of its quota automatically- no restrictions
Further borrowing high rates of interest
Repayment in 3 to 5 years

Quota serves three purposes

Constitutes resources to IMF
Basis for determining how much a member country can borrow (SDRs)
Determines voting power of member

Special Drawing Right (SDRs)

• Created by IMF in 1969 and started with effect from January1, 1970

• To supplement international reserves of gold and foreign exchange

• Accounting entries in books of IMF

• Genuine international reserves

• International Monetary Fund (IMF)

• Also known as paper gold

• Only to be used in dealings among central banks to settle BoP deficits or surpluses

• Not in private commercial dealings

• Not backed by gold

• Created “out of thin air” !

• From 1974, value of SDR tied with a basket of currencies

Composition( 2015-20)

41.73 % US $

30.93% Euro

10.92% Chinese Yuan

8.33 % Japanese Yen

8.09 % Pound Sterling

Other Credit Facilities

a)Buffer Stock Financing Facility (BSFF) :1969

Ø For financing commodity buffer stock by member countries

Ø Facility is equivalent to 30% of the borrowing members quota

b) Extended Fund Facility (EFF): 1974

Ø Provides credit to meet BoP deficits for longer periods up to 10 years

Ø In amounts larger than their quota

c) Structural Adjustment Facility (SAF): 1986

Ø Concessional adjustment to poorer LDCs to solve BoP problems and carry out medium term macro economic and SAPs

Ø ESAF in 1987

d)Compensatory and Contingency Financing Facility (CCFF): 1988

Ø compensation for temporary shortfalls or excesses in cereal import costs

International Bank for Reconstruction and Development (IBRD)

• Product of Brettonwood conference

• Popularly called World Bank

• Provides loans and developmental assistance to ‘creditworthy’ poor and middle income countries

• Organizationally similar to IMF

• Website :- www.worldbank.org

• Head Quarters : Washington DC

• President: David Malpass

Objectives

ü Assist the reconstruction and development of territories of members by facilitating the investment of capital for productive purposes

ü To promote private investment by means of guarantee or participation in loans

ü To promote long range balance growth of international trade and maintenance of equilibrium in BOP

ü To affect international investment and to assist a smooth transition from a wartime to peacetime economy

Organisation

• Owned by 189 members

• Voting power proportional to subscription

• Each country appoints a Governor and Alternative Governor, meet once in year

Financing Policy

• Main task is promote growth of middle income and poor countries

• Provides developmental assistance

• Resources are raised form financial market by selling bonds and other assets

Financing Policy

• Lends indirectly by guaranteeing loans made by private investor

• Lends only to govt or have the guarantee of the govt in whose territory the borrower is located

q Special Action Programme (SAP): 1983

• To assist member countries in adjusting to the current economic environment

• Support structural adjustment, policy changes, production for exports, maintenance of economic infrastructure

q Structural Adjustment Facility (SAF): 1985

• To reduce BoP deficits of countries while maintaining or regaining the economic growth- Used to finance imports

• ESAF in 1987

International Development Association (I D A)

• Affiliate of World Bank

• Established in 1960 to supplement IBRD

• Make available loans to developing countries on softer terms and for longer periods

• “Soft loan window”

• 173 member countries

Objectives

To provide supplementary finance to LDCs on easy and flexible terms
To promote economic development, increase productivity and thus raise std. of living in LDCs
To supplement objectives of World Bank

Financing Policy

• Grants loans to projects productive or unproductive

• Interest-free loans

• Loans for longer periods, that is 35 to 40 years

• 10 year grace period when no payment

• Repayable in foreign exchange

• Loans are known as credits which are made to governments only

• Given to projects for which no assistance is provided by World Bank

• Before approving IDA considers 3 criteria: poverty, performance and project criterion

• Sanction credits for agriculture, education, health, nutrition, water supply, sewerage etc.

International Finance Cooperation (IFC)

• Affiliate of World Bank

• Private sector arm of IBRD

• Established in July 20, 1956

• 184 member countries

Objective

Providing capital to private enterprises in LDCs without Govt guarantee

Investment Policy

Ø Considers only those enterprises which are predominantly industrial and contribute to the economic development of the country

Ø Projects must be in private sector and productive in nature

Ø Enterprises should be experienced and competent and loan should not be more than half of capital of the enterprise

• Provides assistance to large, medium and small scale industries

• Provides assistance in three ways

Direct investment both in the form of loans and equity participation
By securing foreign and local capital
By providing technical assistance

Multilateral Investment Guarantee Agency (MIGA)

Established in 1988
International finance institution
181 member countries
Primary objective is to encourage the flow of FDI in to the developing countries
Offers political risk insurance and credit enhancement incentives

Protect foreign investments against political and non-commercial risks

• Insures only new investments

• Provides promotional and advisory services to the govts of LDCs to improve the investment climate

• Tries to establish credibility among investors and improve their credit rating

Economic Integration

Ø A group of counties come together and agree to cooperate in international trade by various means

Ø Countries place differential treatment to their trading partners

Ø Countries join together to create a larger economic unit

Ø Special relationship among members within the group

• Levels of Economic Integration

Free Trade Area
Customs Union
Common Market
Economic Union

(i) Free Trade Area

The most common integration scheme
No Internal Tariffs (all members remove tariff on each others product)
External Tariffs could be different
Retains independence of establishing trade policies with non-members

Examples

U.S-Israel,

European Free Trade Area (EFTA)

(ii) Customs Union

Second level of economic integration
No Internal Tariffs
Common External Tariffs
Group adopts common external commercial policy towards nonmembers
Group acts as one body

Examples

France-Monaco

Italy-San Marino.

(iii) Common Market

Third level of economic integration
No Internal Tariffs.
Common External Tariffs and common external trade policy for nonmembers
Free movement of factors (labour and capital)

Example

Southern Cone Common Market

(MERCOSUR) - Argentina, Brazil, Paraguay, Uruguay, Bolivia and Chile.

(iv) Economic Union

Most comprehensive of all 4 forms
All features of common market
No Internal Tariffs
Common External Tariffs
Free flow of labor and capital
Integration and co-ordination of economic policies
Harmonization monetary policies, taxation, and government spending
When economic union adopts Common currency it becomes monetary union

Example : European Union - Full monetary union (1999)

Regional Economic Integration

South Asian Association for Regional Cooperation (SAARC)

ò Formed in December 1985

ò Brainchild of Zia ul Rahman (1979)

Objectives

Promotion of economic welfare
Improve quality of life in the region
Accelerate rate of economic growth
Promotion of collective self reliance
To strengthen active collaboration and cooperation

Members

Bangladesh
Bhutan
India
Maldives
Nepal
Pakistan
Sri Lanka
Afghanistan

Eight members and 9 Observers

SAARC secretariat (headquarters): Kathmandu

Secretary General : Amjad B Hussian

Eighth SAARC summit (New Delhi 1995) endorsed SAPTA – (SAARC Preferential Trading Arrangement)

SAPTA is for promotion of intra-regional trade and economic cooperation amoung SAARC nations through extension of tariff and other concessions

Association of Southeast Asian Nations (ASEAN)

Ø Regional inter-governmental organisation

Ø Comprises 10 south east Asian countries

Ø Primary Multinational group in Asia

Ø Formed on August 1967

Ø Headquarters :Jakarta

Ø Secretary General: L Jock Hoi

Indonesia
Malaysia
The Philippines
Singapore
Thailand
Laos
Myanmar
Brunei
Cambodia
Vietnam

Ten members and 2 Observers

Ø Fastest growing economies in the region

Ø Principal aim is to accelerate economic growth, social progress and socio cultural evolution among its members

Ø The protection of regional stability and the provision of a mechanism to resolve differences

Ø Reduced Tariff and non-tariff barriers, guaranteed member access to markets, and harmonized investment incentives.

European Community (EC) or European Union (EU)

• European Community (EC) was founded under the Treaty of Rome in 1957 with 6 countries

• EC consist of three organisations based on separate treaties

1) European Steel and Coal Community (ESCC)

2) European Atomic Energy Community (EAEC or Euratom)

3) European Economic Community (EEC)

Maastricht Treaty in 1993 renamed the European Community (EC) to European Union (EU)

Objectives

Elimination of customs duties between members
Establishment of common customs tariff and common external commercial policy
Abolition of obstacles to freedom of movement of persons, services and capital between member countries
Establishment of common policy with respect to agriculture and transport

• Single European Act 1986 led to the formation of single internal market for EC

• A true common market for goods, people and money by 1992

• EURO, the official currency of EU used by 19 countries (European Monetary Union) from January 1, 1999

• EC institutions - The European Commission, Council of Ministers, European Parliament, European Court of Justice

North American Free Trade Agreement (NAFTA)

ò Extension of US-Canada Agreement (CUSTA) of 1988

ò Later Mexico joined in 1991

ò NAFTA commenced from January 1994

Objectives

a) Free trade area between members

b) Fair competition and facilitation of cross border movement of goods and services

c) Increase investment opportunities

d) Protection of intellectual property rights

• Covers trade, financial services and dispute settlement

• Benefits similar to the E.U. in terms of one Large market

• Additionally Mexico is a different economy with different comparative advantages

• prevents firms from looking for cheap labor in outside markets

• Encourage foreign investment in this market

• Increase competitiveness in outside markets

• Labor and environmental issues

Effects of Economic Integration

Ø Jacob Viner (1950)

Static effects of integration

Trade Creation Trade Diversion

Trade Creation

Economic integration leads to a shift in the product’s origin from a domestic producer whose cost are higher to a member producer whose resource cost is lower
Movement towards free trade allocation of resources
Beneficial and increases in welfare

Trade Diversion

Economic integration leads to a shift in the product’s origin from a non-member producer whose cost are lower to a member country producer whose resource cost are higher
Movement away from free trade allocation of resources
Could reduce welfare

• Effects of Economic Integration

Other effects

Many economic advantages
Reduced Import Prices, Increased competition and economies of scale, Higher factor Productivity
Political Factors and power in international markets

Optimum Currency Area

¢ Developed by Mundell 1961 and McKinnon 1963

¢ Refers to area or block or group of countries whose national currencies are linked through permanently fixed exchange rates

¢ Eliminates uncertainty when exchange rates are flexible

¢ Greater flow of trade and investment

¢ Price stability

¢ No need of government intervention

Will succeed if

Ø Greater is the mobility of resources among OCA

Ø Greater is the structural similarities

Ø More willing to co-ordinate the fiscal, monetary and other policies

January 1, 1999, 11 countries of EU fixed exchange rate with respect to EURO

Euro Currency Market

• Refers to commercial bank currency deposit outside the country of their issue

• Used by international banks, MNCs and govts

• Mostly short-term funds (Money market)

• Initially only $ was used Euro Dollar Market

• Now Yen, Pound, Franc Euro Currency Market

Example

deposits of US $ in England is called Euro Dollar
Pound Sterling deposits outside UK is called Euro Sterling

Euro Bond Market

• Long-term debt securities that are sold outside the borrower’s country to raise long term capital in a currency other than currency of the country where bond in sold

• Different from foreign bond

Example:- US company selling bonds in London denominated in Dollar

Prepared By

Dr. SHABEER K P

Assistant Professor

P G and Research Dept of Economics

Government College

Kodanchery, Kozhikode

Mobile : 9961 48 86 83

kp.shabeer78@gmail.com

Dr. Shabeer K P

Monday, 27 April 2020

Asset Market or Portfolio Balance Approach

Saturday, 25 April 2020

Monetary Approach to Balance of Payments

Thursday, 23 April 2020

International Economic Integration

Tuesday, 21 April 2020

Purchasing Power Parity Theory

Sunday, 19 April 2020

Elasticity and Absorption Approach to Balance of Payment

Friday, 17 April 2020

Tariff and Non Tariff Barriers To Trade

Wednesday, 15 April 2020

GATT and WTO

Monday, 13 April 2020

Bretton Woods Twins : IMF & World Bank

Saturday, 11 April 2020

International Monetary System

Friday, 10 April 2020

Balance of Payments

Thursday, 9 April 2020

Foreign Exchange Market

Wednesday, 8 April 2020

International Trade under Imperfect Competition

Monday, 6 April 2020

Modern Theory of International Trade

Sunday, 5 April 2020

Traditional Trade Theories

Saturday, 4 April 2020

Economics of Business and Finance

Wednesday, 1 April 2020

Basic Econometrics

UGC Economics: International Economics

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