THE OPEN ECONOMY AND BALANCE OF PAYMENYTS

TYPES OF ECONOMY
CLOSED OR AUTARKY:No linkages with rest of the world. OPEN ECONOMY:Economic linkages between countries through two channels. TRADE CHANNELS FINANCE CHANNELS

ISSUES INVOLVED IN INTERNATIONAL TRADE

Increased opportunities Restrictions on flow of goods Restrictions on flow of factors of production Multiplicity of currencies

REASONS FOR INTERNATIONAL TRADE

Unequal distribution of natural resources Difference in technology Different preferences Cost advantages

THEORIES OF INTERNATIONAL TRADE

Theories of international trade answer the question WHY DOES THE INTERNATIONAL TRADE TAKE PLACE? Main theories of international trade : 1.THEORY OF ABSOLUTE ADVANTAGE 2.THEORY OF COMPARATIVE ADVANTAGE 3.THEORY OF OPPORTUNITY COST 4.H-O THEORY OR GENERAL THEORY

THEORY F ABSOLUTE ADVANTAGES

Adam Smith, the Father of Economics, thought that the trade between two cuntries would be beneficial if one country could produce one commodity at an absolute advantage over the other country and another country ,in turn, produce another commodity at an absolute advantage over the first.

TABLE
No. of units of wheat r per unit of labour No. of units of wheat Per Unit of labour USA 10 UK 4

COMPARATIVE COST THEORY

1. 2. 3. 4. 5. 6. The theory was first systematically formulated by the English economist DAVID RICARDO IN 1817. Assumption of the theoryLabour is the only element of cost of production. Labour is perfectly mobile within the country but perfectly immobile between countries. Labour is homogenous. CONSTANT RETURN TO SCALE ARE IN OPERATION. Free trade, perfect competition,full employment and no transport cost. There are only two countries and two commodity

TWO- COUNTRY TWO COMMODITY Model

Country no. Of units no. Of unit exchange

Of labour of labour ratio Per unit per unit domestic Of cloth of wine

England 100 1 wine= 1.2 cloth

120

The economic gains from the trade

Division of labour and specialization Gains to consumers Price stability Improvements in the methods of production Economies of scale Increase in income and employment Helpful in economic development Cultural and educational importance Encouragement to international cooperation and peace.

PROTECTIONISM
There may be two main policies related to international trade:

1.FREE TRADE:Free trade refers to the the Trade that is free from all artificial barriers Of tariffs, quantitative restrictions, exchange control etc. 2.PROTECTION: Protection refers to government policy of providing protection to domestic industries from foreign industries. Various forms of protection: TARIFFS, QUANTITATIVE RESTRICTIONS (QUATA), EXCHANGE CONTROL

1. Infant industry argument:Frederic List Nurse the baby, protect the child and free the adult. 2. Diversification argument 3.Improving BoP 4. Anti dumping 5.Employment argument 6.National defence 7.Key industry argument 8.Keeping money at home 9.The pauper labour argument 10.Bargaining

Arguments in favour of protection

Demerits of protection
1 .Protection is against the interests of consumers as It increases prices and reduces variety and choice. 2. Protection makes producers and sellers less quality conscious 3. It encourages domestic monopolies. 4. Even inefficient firms may feel secure under protection. 5 .Protection leaves the arena open to corruption. It reduces the volume of international trade. 6 .Protection leads to uneconomic utilization of world,s

Supply and demand analysis of trade and tariff

Tariffs in international trade refers to the duties or taxes imposed on internationally traded commodities when they cross national borders.

Classification of tariffs
Export duties Import duties Specific duties Ad-Volerem duties Compouned duties Single- column tarif Double column tariff

Impact of tariffs
Protective Effect Consumption Effect Redistribution Effect Revenue effect Income and Employment Effect Competitive effect Terms of trade effect BoP Effect

Economic cost of tariffs

Barriers to international trade result in inefficiencies. While the government and domestic producers Gain from the imposition trade the loss of domestic consumers exceeds the total gain. Hence ,,on the whole there is an economic loss due to the impediment to trade

The determination of foreign exchange rate

Exchange Rate
The rate at which the unit of one currency will, at any particulae time exchange for another is called the rate of exchange and may be defined as the price of the unit of one currency expressed in terms of another currency.eg Rs.45=$1

The determination of exchange rates

Three main theories of exchange rate determination: Mint Parity Theory Purchasing Power Parity Theory(PPP Theory). Balance of Payments Theory or Equilibrium Theory of Foreign Exchange

Mint parity theory

PPP Theory
The relative values of national currencies especially when they are not on gold standard, in the long run, are determined by their relative purchasing power in terms of goods and services. Example Assume that a particular bundle of goods in India costs Rs. 45 and the same in USA costs $ 1 . Then the exchange rate will be in equilibrium if the exchange rate is $1=Rs. 45. This is absolute version of PPP theory.

Relative Version of PPP Theory

A change in the purchasing power of currencies will be reflected in their exchange rates.The index number of prices may be made use of to determine the Purchasing power parity. ER= Er x Pd/Pf Where, ER=Equilibrium Exchange Rate Er = Exchange Rate in Reference Period Pd=Domestic price index Pf=Foreign Country,s Price Index

BoP Theory
The BoP theory , also known as the Demand and Supply theory and the general equilibrium theory of exchange rate ,holds that foreign exchange rate ,under free market condition , is determined by the conditions of demand and supply in the foreign exchange market. The value of currency appreciates when the demand for it increases and

Floating and Fixed Exchange Rates

FIXED RATES: A fixed exchange rate is Where the value of a currency is fixed in terms of other currencies, and does not change in accordance with a change in the market forces of demand and supply Although a change is allowed under exceptional circumstances by the authority.Two main terms: DEVALUATION REVALUATION FLOATING RATES:A floating exchange rate is where the value of a currency is allowed to change accordance with the underlying economic fundamentals, and hence with the demand- supply forces.Two main terms Depreciation Appreciation

Factors affecting Rate of Exchange

Interest Rate Price Level Growth Rate Other Economic Factors: fiscal deficit, Competitiveness on countrys Exports, Demand and supply elasticities of countrys imports and exports

Concept of Sterilization
The resorting of central bank to contractionary or expansionary policies to correct the imbalances created by changes in foreign exchange reserves is referred to as sterilization.

International Financial Institutions

The International Monetary Fund (IMF) The International Bank for Development and Reconstruction The International Development Agency (IDA) The International Finance Corporation (IFC) The Asian Development Bank (ADB) The Bank for International Settlements (BIS)

Indias Overall Balance of Payments

A.CURRENT ACCOUNT 1.MERCHANDISE . a. Exports (on f. o. b. basis) b. Imports (on c. i. f. bais)

Credit

Debit

Net

2.INVISIBLES (a + b + c ) a. Services i. Travel ii. Transportation iii. Insurance iv. G.n.i.e. V. Miscellaneous b. Transfers vi. Official

B. CAPITAL ACCOUNT 1. FOREIGN INVESTMENT (a + b ) a. In India i. Direct ii. Portfolia b. Abroad 2. LOAN (a + b + c) a. External Assistance i. By India ii. To India b. Commercial Borrowings (MT and LT ) i. By India ii. To India c. Short-term 3. BANKING CAPITAL (a + b )

The following data are extracted from the quarterly report, Jan.-Mar. 2000 of Indias overall balance of payment in rupees. You are required to prepare a balance of payment statement (BoP) indicating the increase/decrease in foreign exchange reserves

(Rs. crore)

Merchandize exports Merchandize imports Travel exports Travel imports Transportation (credit) Transportation (debit) Insurance (net) G.n.i.e. (credit) G.n.i.e. (debit) Miscellanceous services (net) Debit transfers Credit transfers Short-term loans to India Compensation to employees (net)

44,912 69,949 3,897 2,325 2,086 2,310 +89 701 299 7,603 37 15,053 561 168

Credit A.CURRENT ACCOUNT 1.MERCHANDISE . a. Exports (on f. o. b. basis) b. Imports (on c. i. f. bais)

Debit

Net

2.INVISIBLES (a + b + c ) a. Services i. Travel ii. Transportation iii. Insurance iv. G.n.i.e. V. Miscellanceous b. Transfers vi. Official vii. Private