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

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 resoureses

• 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 OF ABSOLUTE ADVANTAGES

• Adam Smith, the Father of Economics, thought that the trade between two countries 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

USA UK

No. of units of wheat 10 4

per unit of labour

No. of units of wheat 3 7

Per Unit of labour

COMPARATIVE COST THEORY

• The theory was first systematically formulated by the English economist DAVID RICARDO IN 1817.

• Assumption of the theory-1. Labour is the only element of cost of production.2. Labour is perfectly mobile within the country but

perfectly immobile between countries.3. Labour is homogenous.4. CONSTANT RETURN TO SCALE ARE IN

OPERATION.5. Free trade, perfect competition, full employment and no

transport cost.6. There are only two countries and two commodity

TWO- COUNTRYTWO –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 100 120 1 wine= 1.2 cloth

PORTUGAL 90 80 1 wine= .88 cloth

In event of trade taking place, Portugal will gain if it can get anything more than .88 units of cloth in exchange of 1 unit of wine and England will gain if it has to part with less than 1.2 units of cloth against 1 unit of wine. Theactual rate of exchange will be determined by the reciprocal demand.

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 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 (Quota) &

Exchange Control

Arguments in favour of protection

1. Infant industry argument: ‘Nurse the baby, protect the child and free the adult’.

2. Diversification argument

3.Improving BOP

4. Anti dumping

5.Employment argument

6.National defense

7.Key industry argument

8.Keeping money at home

9.The labour argument

10.Bargaining

Demerits of protection1 .Protection is against the interests of consumers as It increases prices and reduces variety and choice.2. Protection makes producers and sellers less quality

conscious3. 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 Resources.

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-Valorem duties• Bound duties• Single- column tariff• 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 producer’s gain from the imposition trade and the loss of domestic consumers exceeds the total gain. Hence, on the whole there is an economic loss due to the impediment to trade.

Exchange Rate

• The rate at which the unit of one currency will, at any particular 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 Foreign Exchange Rate

• Interest rate

• Price levels

• Growth rate

• Other economic fundamentals: various other economic factors like the fiscal deficit, the competitiveness of a country’s exports, the demand and supply elasticities of its exports and imports, etc. also will affect the 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 theoryWhen the currencies of two countries are on metallic standard (gold or silver standard), rate of exchange between them is determined on the basis of parity of minorities between currencies of the two countries. Thus, the theory explaining the determination of exchange between countries which are on the same metallic standard (say gold coin standard), is known the Mint Parity Theory of foreign exchange rate.

By mint parity is meant that the exchange rate is determined on a weight-to-weight basis of two currencies, allowances being made for the parity of the metallic content of the two currencies.' Thus, the value of each coin (gold or silver) will depend upon the amount of metal (geld or silver) contained in the coin; and it will freely circulate between the countries. For instance, before World War I, England and America were simultaneously on a full-fledged gold standard.

PPP TheoryThe 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 to determine the Purchasing power parity.

•ER= Er * 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 depreciate when the supply of it increases.

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

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 or World Bank• The International Development Agency (IDA)• The International Finance Corporation (IFC)• The Asian Development Bank (ADB)• The Bank for International Settlements (BIS)