Beruflich Dokumente
Kultur Dokumente
Introduction:
In the modern world, there is hardly any country which is self-sufficient
in the sense that it produces all the goods and services it needs.
Every country imports from other countries the goods that cannot be
produced at all in the country or can be produced only at an unduly high
cost as compared to the foreign supplies.
During a given period of time, the exports and imports may be exactly
equal, in which case the balance of trade is said to be in balance. But this
is not necessary because those who export and import are not necessarily
the same persons. If the value of exports exceeds the value of imports, the
country is said to have an export surplus. On the other hand, if the value
of its imports exceeds the value of its exports, the country is said to have
a deficit balance of trade.
The capital account, on the other hand, deals with capital receipts and
payments of debts and claims. The current account of the balance of
payments affects the level of national income directly. For instance, when
India sells its currently produced goods and services to foreign countries,
the producers of those goods get income from abroad.
In other words, current account receipts have the effect of increasing the
flow of income in the country. On the other hand, when India imports
goods and services from foreign countries and pays them money which
would have been used to demand goods and services within the country
money flows out to foreign countries.
The Table 2.4 (given below) gives the position of India’s balance of
payments on current account for the years 2007-08 to 2011-12. In this
table balance of payments the visible as well as invisible items of trade
are given. The visible items are export-import of goods and the invisible
items of balance of payments on current account are travel,
transportation and insurance, interest on loans given and other
investment income on private and official transfers.
Both visible and invisible items together make up the current account.
Interest on loans, tourist expenditure, banking and insurance charges,
software services etc., are similar to visible trade since receipts from
selling such services to the foreigners are very similar in their effects to
the receipts from sales of goods; both provide income to the people who
produce the goods or services.
It will be noted from Table 2.4 above that the most important item in the
balance of payments on current account is balance of trade which refers
to imports and exports of goods. In Table 2.4 balance of trade does not
balance and shows a deficit in all the seven years. In the years 2011-12
and 2012-13 trade deficit has substantially increased. Trade deficit was
over 10 per cent of GDP in both these years.
In fact, it is huge trade deficit in these two years that has caused huge
current account deficit of over 4% of GDP in these two years. Economic
slowdown in advanced countries and its spillover effects in Emerging
Market Economies coupled with high crude oil and gold prices were
responsible for sharp increase in trade deficit.
It may be noted that high current deficit tends to weaken the rupee by
raising the demand for US dollars. In 2011- 12, the current account deficit
tended to weaken the rupee by raising the demand for US dollars. In
2011-12, the current account deficit was 4.2 per cent of GDP. Since
capital inflows in this year were not adequate to finance the current
account deficit, RBI had to withdraw 12.8 billion US dollars from its
foreign exchange reserves to meet the demand for US dollars.
In the year 2012-13 the current account deficit has been estimated to be
even higher at 4.8 per cent of GDP, capital inflows through portfolio
investment by FIIs had picked up in the latter half of 2012-13 but capital
inflows through FDI had fallen. However, we managed to meet such large
account deficit through capital inflows. In fact we added to our foreign
exchange reserves by $3.8 billion in 2012-13.
Since in the recent years, 2011-12 and 2012-13 current account deficit has
widened, this has increased the balance of payments vulnerability to
sudden reversal of capital flows, especially when sizable flows comprise
debt and volatile portfolio investment by FIIs. The priority has therefore
been to reduce current account deficit (CAD) through improving trade
balance. Efforts have been made to promote exports by diversifying the
export commodity basket and export destinations.
The two components together met nearly two-thirds of the trade deficit
that was more than 10 per cent of GDP in 2011-12. Remittances
particularly are known to exhibit resistance when the country is hit by
external shock as was evident during the global crisis of2008.
Balance of Payments on Capital Account:
In the balance of payments on capital account given in Table 2.5
important items are borrowings from foreign countries and lending
funds to other countries.
(ii) Commercial borrowing under which the Indian Government and the
private sector borrow funds from world money market at higher market
rate of interest.
Capital inflows in the capital account can be classified into debt creating
and non-debt creating. Foreign investment (both direct and portfolio)
represents non-debt creating capital inflows, whereas external assistance
(i.e. concessional loans taken from abroad), external commercial
borrowing (ECB) and non-resident deposits are debt-creating capital
inflows.
It will be seen from Table 2.5 that during 2007-08, there was net capital
inflow of 43.3 billion US dollars on account of foreign investment (both
direct and portfolio). Table 2.5 gives the position of India’s balance of
payments in capital account for seven years, 2007-08,2008-09,2009-
10,2010- 11, 2011-12 and 2012-13.
When all items of balance of payments on capital account are taken into
account we had a surplus of 107.9 billion US dollars in 2007-08. Taking
into current account deficit of $ 15.7 billion on current account in year
2007-08 there was accretion to our foreign exchange reserves by $ 92.2
billion in 2007-08.
Global financial crisis affected our capital account balance as there was
reversal of capital flows after Sept. 2008 with the result that we used $
20.1 billion of our foreign exchange reserves in 2008-09 resulting in
decrease of our foreign exchange reserves. That is, because we used our
foreign exchange reserves equal to $ 20.1 billion, there was decline in our
foreign exchange reserves by $ 20 billion in 2008-09.
However, in 2011 -2012 and 2012-13 the situation regarding capital flows
changed significantly and capital flows were not sufficient to meet the
large current account deficit (CAD). Consequently, in 2011-12 withdrawal
from foreign exchange reserves of 12.8 million US dollars was made.
Capital flows are driven by pull factors such as economic fundamentals of
recipient countries and push factors such as policy stance of source
countries.
This would ensure that to the extent current account defect is bridged
through capital surplus it would be better if it is done through stable and
growth-enhancing foreign direct investment flows. In the present
international financial situation, reserves are the first line of defence
against the volatile capital flows. However, the decline in reserves as a
percentage of GDP is a source of concern.
When all items of balance of payments of capital account are taken into
account we had a surplus of 6.8, 53.9 and 59.7 billion US dollars in 2008-
09, 2009-10 and 2010-11. Small size surplus on capital account of 6.8
billion US dollars in 2008-09 was due to large portfolio capital outflows
by FII, which occurred because of global financial crisis in 2008-09. As a
result of this, capital flows fell short of current account deficit of 27.9
billion US dollars resulting in deficit of 20.1 billion US dollars in 2008-
09.
At the back of these variables lie the supply factors, production function,
the state of technology, tastes, distribution of income, economic
conditions, the state of expectations, etc. If there is a change in any of
these variables and there are no appropriate changes in other variables,
disequilibrium will be the result.
Exports may be small due to the lack of exportable surplus which in turn
results from low production or the exports may be small because of the
high costs and prices of exportable goods and severe competition in the
world markets.
Important causes of small exports are the inflation or rising prices in the
country or over-valued exchange rate. When the prices of goods are high
in the country, its exports are discouraged and imports encouraged. If it
is not matched by other items in the balance of payments, disequilibrium
emerges.
The above fact has an important lesson that must be borne in mind. If a
country has no foreign currency reserves or it has no assets to sell to pay
for the imports and if nobody is willing to lend to it, it will have to cut
down its imports which will reduce productive activity in the economy
and adversely affect economic growth of the country.
Such a crisis situation arose in India in 1991 when our foreign exchange
reserves had fallen to a very low level and no one was willing to lend to us
or give us aid. In fact, due to loss of confidence of foreign investors,
capital outflows were taking place.
The above equation reveals that trade balance (NX) is a function of level
of domestic income (Yd) and foreign income (Yf) and real rate of exchange
(R). An increase in the domestic income due to higher industrial growth
or fall in real exchange rate of rupee will adversely affect the trade
balance (NX) by increasing imports. lf– Id in equation (ii) measures net
foreign investment, i.e. net capital inflows.
Further, the above equation shows that higher interest rate in India as
compared to that in the foreign country such as the United States will
cause large capital inflows into India. Such capital inflows actually took
place in India 2009-10 and 2010-11. Due to large capital inflows into the
Indian economy our foreign exchange reserves increase. However, when
there are large capital outflows as occurred during 2008-09, our foreign
exchange reserves decline.
1. Direct Methods:
The direct methods of exchange control are adopted by the central bank
with the object of restricting the use and the quantity of foreign
exchange. These include intervention, exchange restriction, exchange
clearing agreements and payments agreements.
Secondly, it is easier for a country to sell the home currency and buy the
excess amount of foreign exchange through the use of home currency. It
is greatly constrained in the sale of foreign currency.
Firstly, the priorities are often laid down by the government or central
banking officials in an arbitrary way.
Secondly, the procedures related to the processing and sanctioning of
applications for the grant of foreign exchange are quite time-consuming.
After Second World War, the sterling area constituted by England and
Commonwealth countries essentially represented a multi-lateral
payments agreement. Another prominent example of multilateral
arrangement was the European Payments Union (EPU) that existed
between 1950 and 1958. Every clearing agreement has a tendency to
restore the BOP equilibrium in an automatic way.
Fifthly, the clearing agreements are also likely to have discouraging effect
upon the volume of international trade.
On the opposite, if the ‘swing’ is too small, the limit may be reached soon
and the country, faced with the prospect of losing gold, may impose
physical tariff or non-tariff barriers upon trade. Thus there can be a
possibility of trade coming to naught.
2. Indirect Methods:
Apart from the direct methods of exchange control, countries
sometimes resort to indirect methods which are as follows:
(i) Tarrif and Non-Tarrif Restrictions:
The countries can resort to tariffs, import quotas and other quantitative
restrictions. These measures reduce the volume of imports and the
demand for foreign currencies gets reduced. That brings about an
improvement in the balance of payments situation. The quantitative
restrictions on imports result in appreciation of home currency relative
to the foreign currency.
--------------------------------------------------------------------------------------
Exchange control is one of the important means of achieving certain national objectives like
an improvement in the balance of payments position, restriction of inessential imports and
conspicuous consumption, facilitation of import of priority items, control of outflow of capital
and maintenance of the external value of the currency. Under the exchange control, the
whole foreign exchange resources of the nation, including those currently occurring to it,
are usually brought directly under the control of the exchange control authority (the Central
Bank, treasury or a specially constituted agency). Dealings and transactions in foreign
exchange are regulated by the exchange control authority. Exporters have to surrender the
foreign exchange earnings in exchange for home currency and the permission of the
exchange control authority have to be obtained for making payments in foreign exchange. It
is generally necessary to implement the overall regulations with a host of detailed
provisions designed to eliminate evasion. The allocation of foreign exchange is made by
the exchange control authority, on the basis of national priorities.
The various methods of exchange control may be broadly classified into (1) Unilateral
methods and (2) Bilateral/multilateral methods.
Unilateral Methods
Unilateral measures refer to those methods which may be adopted by a country unilaterally
i.e., without any reference to or understanding with other countries. The important unilateral
methods are outlined below.
1. Regulation of Bank Rate: A change in the bank rate is usually followed by changes in all
other rates of interest and this may affect the flow of foreign capital. For example, when the
internal rates of interest rise, foreign capital is attracted to the country. This causes an
increase in the supply of foreign currency and the demand for domestic currency in
the foreign exchange market and results in the appreciation of the external value of the
currency. A lowering of the bank rate is expected to produce the opposite results.
2. Regulation of Foreign Trade: The rate of exchange may be controlled by regulating the
foreign trade of the country. For example, by encouraging exports and discouraging
imports, a country can increase the demand for, in relation to supply, its currency in the
foreign exchange market and thus bring about an increase in the rate of exchange of the
country’s currency.
3. Rationing of Foreign Exchange: By rationing the limited foreign exchange resources, a
country may restrict the influence of the free play of market forces of demand and supply
and thus maintain the exchange rate at a higher level.
4. Exchange Pegging: Exchange pegging refers to the policy of the government of fixing the
exchange rate arbitrarily either below or above the normal market rate. Pegging operations
take the form of buying and selling of the local currency by the central bank of a country in
exchange for the foreign currency in the foreign exchange market, in order to maintain an
exchange rate whether, it is overvalued or undervalued. Thus, pegging may be pegging up
or pegging down. Pegging up means holding fixed overvaluation, i.e., to maintain the
exchange rate at a higher level. Pegging down means holding fixed undervaluation, i.e., to
maintain the exchange rate at a lower (depressed) level. In the case of pegging up, the
central bank shall have to keep itself ready to buy unlimited amount of local currency in
exchange for foreign currencies at a fixed rate, because overvaluation tends to increase the
demand for foreign currencies by creating import surplus. In the case of pegging down, the
central bank or central agency shall have to keep itself ready to sell any amount to local
currency by creating export surplus. Similarly, pegging up involves holding of sufficient
amount of foreign currencies while pegging down involves holding of sufficient amount of
local currency by the central bank. It goes without saying that pegging up, is more difficult
to maintain as it requires huge amounts of foreign currencies which is difficult to obtain. As
such pegging up can be adopted only as a temporary expedient. It should be noted that
intervention by a government in the foreign exchange market has the effect of neutralizing
the forces of demand and supply of foreign exchange. However, it is generally assumed
that government intervention or pegging up and pegging down operations should be used
as temporary expedients to remove fluctuations in the exchange rate.
5. Multiple Exchange Rate: Multiple exchange rates refer to the system of the fixing, by a
country, of the different rates of exchange for the trade or different commodities and/or for
transactions with different countries. The main object of the system is to maximize the
foreign exchange earning of country by increasing exports and reducing imports. The entire
structure of the exchange rate is devised in a manner that makes imports cheaper and
exports more expensive. The multiple exchange rate system has been severely
condemned by the IMF.
6. Exchange Equalization Fund: The main object of the Exchange Equalization Fund, also
known as the Exchange Stabilization Account, is to stabilize the exchange rate of the
national currency through the sale and purchase of foreign currencies. When the demand
for domestic currency exceeds its supply, the fund starts purchasing foreign currency with
the help of its own resources. This results in an increase in the demand for foreign currency
and increases the supply of the national currency. The tendency of the rate of exchange of
the national currency. to rise can thus be checked. When the supply of the national
currency exceeds demand and the exchange rate tends to fall, the Fund. sells the foreign
currencies and this increases the supply of foreign currencies and arrests the tendency of
the exchange rate of the domestic currency to fall. This sort of an operation may be
resorted to eliminate short term fluctuations.
7. Blocked Accounts: Blocked accounts refer to bank deposits, securities and other assets
held by foreigners in a country which denies them conversion of these into their home
currency. Blocked accounts, thus, cannot be converted into the creditor country’s currency.
Under the blocked accounts scheme, all those who have to make payments to any foreign
country will have to make them not to the foreign creditor directly but to the central bank of
the country which will keep the amount in the name of the foreign creditor. This amount will
not be available to the foreigners in their own currency, but can be used by them for
purchase in the controlling country.
Bilateral/Multilateral Methods
1. Private Compensation Agreement: Under this method, which closely resembles barter, a
firm in one country is required to equalize its exports to the other country with its imports
from that country so that there will be neither a surplus nor a deficit.
2. Clearing Agreement: Normally, importers have to make payments in foreign currency and
while exporters are paid in foreign currency. Under the clearing agreement, however,
importers make payments in domestic currency to the clearing account and exporters
obtain payments in domestic currency from the clearing fund. Thus, under the clearing
agreement, the importer does not directly pay the exporter and hence, the need fore foreign
exchange does not arise, except for settling the net. balance between the two countries.
3. Standstill Agreement: The standstill agreement seeks to provide debtor country some
time to adjust their position by preventing the movement of capital out 01 the county
through a moratorium on the outstanding short-term foreign debts
4. Payments Agreement: Under the payments agreement, concluded between a debtor
country and a creditor country, provision is made for the repayment of the principal and
interest by the debtor country to the creditor country. The creditor country refrains from
imposing restrictions on the imports from the debtor country in order to enable the debtor to
increase its exports to the creditor. On the other hand, the debtor country takes necessary
measures to encourage exports to and discourage imports from the creditor country.
Customs Union: Dynamic Effects and Theory |
International Economics
In this article we will discuss about:- 1. Dynamic Effects of Customs
Union 2. Theory of Customs Union as the Theory of Second Best 3. Intra-
Industry Trade and Customs Union.
If the marginal propensity to consume of a project's workers is 0.75, then 75% of the
workers' income is spent on goods and services that produce income for another
individual or business, and 25% of their income is withdrawn from circulation by
means of savings, taxation or expenditures on foreign goods and services. This same
project has an investment multiplier of 4, which means that for every $1 spent
investing in the project, another $4 of income is generated. The investment multiplier
is calculated as 1/(1-MPC), or 1/(1-0.75), in the example.
Business cycle analysts, central bankers, and policy planners study investment
multipliers on an aggregate level to observe the general flow of wealth in an economy,
and to better understand certain variables such as employment, prices and the velocity
of the money supply. The concept of a multiplier effect is applied in many other areas,
such as unemployment benefits and tax policy.
National Income and The Foreign
Trade Multiplier
National Income and The Foreign Trade Multiplier!
The Import Function:
In an open economy consumers of a country also spend some income on
imported goods.
The imports of a country depend on its level of income. The higher the level of
income, the prices of imported goods and tastes of consumers remaining the
same, the greater will be its imports.
We have shown the import function in Fig. 24.1 where on the X-axis the level of
national income and on the Y-axis imports of a country are measured. It will be
seen that even at zero national income some imports are undertaken by
exporting some capital accumulated in the past or by borrowing from abroad.
Large countries such as the U.S.A., Russia and India have low average
propensity to import and small countries such as Great Britain and Holland have
high average propensity to import. The average propensity to import in India is
between 0.02 and 0.03.
More important concept is the marginal propensity to import. The marginal
propensity to import measures the change in import as a result of increase in
national incomes and is algebraically expressed as ΔM/ΔY where ΔM is the
change in value of imports and ΔY is the increase in national income. If imports
increase by Rs. 3 when national income rises by Rs. 100, the marginal
propensity to import (ΔM/ΔI) will be equal to 3/100 = 0.03 or 3 per cent. If
increase in income by Rs. 100 leads to the increase in imports by Rs. 10, the
marginal propensity to imports is 10/100 = 0.1 or 10 per cent.
The level of national income is in equilibrium (that is, circular flow of income is
constant) when leakage from the income stream in the form of savings is equal
to the injection of investment expenditure. In an open economy, the role of
foreign trade, that is, exports and imports of a country are also to be considered.
Imports by consumers of a country represent the expenditure on imported goods
by the residents of the country and leads to the leakage of some income from
domestic economy.
Therefore, in addition to saving, imports are other form of leakage that occur in
an open economy. On the other hand, exports represent expenditure by the
people of foreign countries on the goods produced in the domestic economy and
are, like domestic investment, injection into the income stream of an open
economy.
S+M=I+X
When a change in any of the above four variables occurs, then the change on the
left side of the above equation must equal the change on the right side if the new
equilibrium is to be achieved.
Hence
ΔS + ΔM = ΔI + ΔX …(1)
Thus, increase in exports (ΔX) has led to the increase in income (ΔY) equal to
Y1 – Y0 which is much greater than change in exports (ΔX). The expression
ΔY/ΔX represents the foreign trade multiplier whose value depends on the slope
of saving-import function curve S+ M which is equal to the reciprocal of the
sum of marginal propensity to save and marginal propensity to import (1/s + m).
How the Foreign Trade Multiplier Works?
The foreign trade multiplier works in the same way as Keynes’ investment
multiplier. When there is increase in exports, it will cause the increase in income
of the exporters and those employed in the export industries. They will save
some of the increase in their incomes and will spend a good part of the increases
in their incomes on consumer goods, both domestic and imported ones.
While savings do not generate further income and represent leakage from the
income stream, expenditure on imports leads to the increase in the incomes of
the foreign countries from which goods are imported. Thus expenditure on
imports also represents a leakage from the income stream as far as domestic
economy is concerned.
But in the next periods, they will make efforts to increase the production of
exported goods and employ more workers. This will generate new income and
employment in the export industries. But the working of multiplier does not stop
here.
Those employed in export industries will spend a good part of their increased
incomes on goods produced by other industries and in this way increases in
income, production and employment will spread in the whole of the domestic
economy.
The equality of exports (X) with imports (M) implies that there is equilibrium in
the balance on the current account. However, it is important to note that it is not
necessary that at equilibrium level of national income exports (X) equal imports
(M).
This equilibrium in the current account balance along with equilibrium of saving
and domestic investment occurs only when exports are equal to imports at the
equilibrium level of income determined by the equality of saving and domestic
investment.
The opposite case can also occur when exports fall below ED. If the exports fall
and the investment-export curve shifts to ld + X2 (Fig. 24.5), the new equilibrium
is reached at income level Y2 at which Id+X2= S + M. In this equilibrium
situation imports are equal to VT which exceeds exports (X2) which are equal to
KT.
Thus, though the open economy is in equilibrium as ld + X2 = S + M at income
level Y2, there exists import surplus or deficit in current account balance which
again implies that there is disequilibrium in the balance of payment on the
current count.
However, in this case of import surplus (i.e. deficit in current account balance),
domestic investment must exceed domestic saving by an equal amount so as to
maintain the equality of Id + X with S + M. This is possible only if a country
borrows from abroad to keep investment greater than domestic savings.
The above analysis shows that while the open economy as a whole may be in
equilibrium, it is not necessary that balance of payment (on current account) will
also be in equilibrium.
The reduction in import duties on the imports and thus making them cheaper
may be another reason for the increase in imports a country. The contractionary
effect of increase in imports on the income and employment in a country is
illustrated in Fig. 24.6. To simplify our analysis we have assumed that there are
no net savings and investment.
In this Fig. 24.6 the export curve is a horizontal straight line since exports are
assumed to be autonomous of changes in national income. The curve M
represents the import function curve which slopes upward showing that it
changes with national income.
The two curves X and M intersect at point E and determine Y0equilibrium level
of national income. Now suppose that there is increase in imports (ΔM = ET),
say due to the change in preferences for foreign goods, and as a result import
function curve shifts above to the position M1, the export curve X remaining un-
changed.
It will seen from Fig. 24.6 that new import function curve M1 and export curve
X intersect at point E1 and as result the equilibrium level of income falls to Y1.
Note that reduction in income is greater than the increase in imports; ΔY is
much greater than ΔM. This is due to the working of foreign trade multiplier
which in the present case works to reduce income.
When the consumers buy more foreign goods and less domestically produced
goods, the demand for domestically produced goods decreases which result in
fall in incomes and employment of those engaged in the domestic industries.
These reduced incomes further reduce the expenditure on the purchase of other
home-produced goods and so on. The reverse process of contraction of income,
production and employment goes on till the multiplier fully works itself out.
It is important to note that initial attempt to increase imports has not finally
resulted in any increase in imports. Imports Y0E at the initial equilibrium income
Y0 are equal to imports Y1E1 in the new equilibrium at the much lower level of
income. This is another paradox which is described as import paradox.
What has actually happened is that the increase in imports and consequent
upward shift in the import function leads to a large contraction in income
through the reverse working of foreign trade multiplier so that in the new
equilibrium at a much lower income, less is imported. This is generally referred
to as income effect.