International trade

Gains from Trade

Adam Smiths Theory of Absolute Advantage

Country should specialize in the production of commodities

which it can produce most efficiently – Lower Cost of Production.

A country tends to specialize in production of commodities in which it has Absolute Advantage

Per Quintal Labour Cost (Man- hour)

Country Rice Jute

India 30 60

Bangladesh 50 20


Would should country’s be doing?

India India should specialise in Rice production. As India has to sacrifice 2 Qtl of Rice for 1 Qtl of Jute. It can import jute from Bangladesh

1Qtl of Rice = 1.5 Qtl of Jute (30/20)


Country Rice Jute

India 30 60

Bangladesh 50 20


Would should country’s be doing?

Bangladesh Should specialise in Jute Import Rice from India As in domestic trade they get 0.4 Qtl of Rice (20/50) for Jute If they trade they get 0.67 Qtl of Rice (20/30) for 1 Qtl of jute


Country Rice Jute

India 30 60

Bangladesh 50 20

Ricardo's Insight What if one country has absolute advantage in both the

commodities?

Is trade possible?

As long as countries have comparative advantage in the production of both the commodities specialisation and trade would always be possible.


Country Rice Jute

India 30 60

Bangladesh 50 80

IndiaIt can produce both the goods efficiently.It has comparative advantage in rice production.It can produce Rice at 60% (30/50) cost then Bangladesh.It has comparative disadvantage in jute because cost of

jute production is twice the cost of rice production.

BangladeshIt has comparative advantage in jute productionRelative cost of jute production ( 80/50 = 1.6 Qtl of rice) isless than India’s(60/30= 2Qtl of rice).

Country Rice Jute

India 30 60

Bangladesh 50 80

Gains from Foreign Trade

Internal Exchange Rate (Quintal)

India

Rice Jute

130/60

0.5

2 1

Bangladesh

Rice Jute

150/80

0.625

1.6 1

Who Gains from Trade?

Who Gains India or Bangladesh?

It depends upon the determination of commodity exchange rate between two countries.

India’s exchange rate ranges between 500Kg to 625 kg of Jute

for 1 Qtl of Rice. Bangladesh it ranges between 1.6 to 2 Qtl of Rice for 1 Qtl of

Jute. If Exchange rate in foreign trade are same as internal rates then

both the country gain.

Heckscher-Ohlin Theory of Trade

The comparative advantage in the cost of production is due to the difference s in the factor endowment of the nations.

It refers to the overall availability of usable resources in the country.

A country tends to specialise in the export of a commodity whose

production requires intensive use of its abundant resources and

imports a commodity whose production requires intensive use of its

scarce resources.

Balance Of Payments

Definition

“It is a systematic record of a country’s economic and financial transactions with the rest of the world, over a period of time”.

Transaction of goods and services and income between an economy and the rest of the world.

It standard double- entry book – keeping. Credit = Debit

The BOP must always balance.

The time period is one year – financial or calendar.

Purpose

It provide data for the Economic analysis of the country’s as the

partner in International trade.

It reveals the changes in composition and magnitude of

foreign trade.

It predicts future performances on past trade performances.

It also revels the weak and strong points in the country’s foreign

trade and thereby Govt intervention for corrective measures.

Balance of Trade vs BOP

Balance of Trade : It refers to the difference in value of Imports and Exports i.e “ Visible Items”

Favourable Balance of Trade : X > M Unfavourable Balance of Trade: X< M

Balance of Payments: Includes both Visible and Invisibles items

( Such as Services by shipping, banking and insurance, interest payment, dividend, expenditure of tourist, foreign

investment, external lending and borrowing, NRI deposits etc)

Components of BOP

Current Account

It includes all transactions which give rise to or use up National Income.

Credit : Value which are receivableDebit: Value which are payable.

a) Merchandise / Visible Exports and Imports Merchandise Exports : Sales of Good abroad Merchandise Imports: Purchase of Goods from aboard

b) Invisible Items Invisible Exports: Sales of Services Invisible Imports: Purchase of Services

c) Unilateral Payments Gifts, Private remittances, grants , disaster relief

Capital Account

Which increase or decrease country’s total stock of capital.

a) Short Term Capital Movement Purchase of short term securities Speculative Purchase of Foreign Currency Cash balances held by foreigners Net balance ( + /- ) of current account

b) Long Term Capital Movement Direct Investments in Shares, bonds and in real estate and physically

assets which investors hold a controlling power. Portfolio investments in stocks and bonds Repurchase and resale of securities Direct export and import of capital goods

c) Gold and Foreign Exchange reserves They are maintained to stabilize the exchange rate of the home currency and to make payments to the creditors in case of deficit.

Components of BOP

Credit (Receipts) Debit (Payments)

Export of Goods Import of Goods

Export of Services Import of Services

Interest profits and Dividend Received Interest profits and Dividend paid

Unilateral Receipt(Gifts, grants, disaster relief)

Unilateral Payments

Current Account Balance

Components of BOP

Credit (Receipts) Debit (Payments)

Foreign Investment – Direct, Portfolio Investment Aboard – Direct, Portfolio

Short Term Borrowings Short Term Lending

Long Term Borrowings Long Term Lending

Foreign Exchange Reserves (+) Foreign Exchange Reserves (-)

Capital Account Balance

BOP are always Balance

BOP is based on double – entry book keeping in which both sides of a transactions, receipt and payment are recorded.

Export:

Outflow of goods / Inflow of foreign currency

Import:

Inflow of Goods / Outflow of foreign currency

Both outflow and inflow are recorded in BOP A/C

Indias BOP

Capital A/C

India’s BOP

Bop Disequilibrium

BOP Equilibrium :

Total Receipt = Total Payment

Demand for foreign Exchange = Supply

BOP Disequilibrium :

Demand > Supply : Deficit

Demand < Supply : Surplus

Deficit in Current A/C is offset by Surplus in Capital A/C

Surplus in Current A/C is offset by a deficit in capital A/C

( By loans / borrowings or depleting its gold /foreign exchange reserves)

Causes and Kinds BOP Disequilibrium

1)Economic Factors

a) Price Change Change in Price level causes BOP disequilibrium. The change in price level may be inflationary or deflationary. Inflation makes import cheaper and export costlier. Increase in imports as domestic prices become higher than import

prices Decrease in exports as domestic price rises. Deficit in BOP

b) Development Disequilibrium Large scale development expenditure increase the purchasing

power Increases demand and prices Increases in large imports.

Its common in developing countries as large scale import of capital goods.


c) Cyclical Disequilibrium

Business cycle fluctuations causes disequilibrium. The country’s which are dependent upon Imports faces

large deficit during inflation Moderate deficit or surplus during depression.

d) Structural Disequilibrium

Depletion of Natural Resources Changes in Technology Alternative source of Supply Development of better substitute


2) Political Factors

Political Instability may experience large capital outflow and inadequacy of domestic investment and production.

War and changes in trade route can also cause disequilibrium.

3) Other Factors Disturbances or crop failure Rapid growth in population leads to large scale imports of

foodgrains. Changes in taste preferences and fashion causes change in

export and import.

Correction of Disequilibrium


A) Automatic Measures

BOP disequilibrium may be automatically corrected If the market forces of demand and supply are allowed to have a free

play, in course of time equilibrium would be restored. For ex

If there is deficit in BOP Demand for Foreign exchange exceeds its supply This result in increase in exchange rate Fall in value of domestic currency Exports cheaper and import costlier Increase in Exports and fall in imports Equilibrium in BOP


1) Monetary measures

a) Monetary Contraction / Deflation

Contraction or Expansion of money supply For Example: Deficit in BOP Contract the Money Supply Reduces purchasing power Decrease the demand Reduces domestic prices Decrease in imports and increase in exports


b) Devaluation

Reduction of the official rate at which the currency is exchanged for another currency

Devaluation is done to improve its BOP Export prices fall, Export increases Import prices goes up, import reduces Deficit of BOP reduces

Condition for the successful working of Devaluation

Elastic demand for imports and exports Structure of Imports and Exports Domestic Price stability ( Should not lead to Price rise) International co-operation Hike in import duties, reduction in export duties, export license, export

promotion programme


c) Exchange Control

Central Govt has complete control over foreign exchange reserves.

Exporters surrender foreign exchange in exchange of domestic currency.

Govt release foreign exchange only for essential imports.

Its not a permanent solution to long – run disequilibrium because it suppresses demand for Imports and not cure Deficit.


2) Trade Measures

Export promotion measures and import substitutions

a) Export Promotion:

Reducing Export duties

Export subsidy

Export incentives and facilities.

b) Import Control:

Increasing Import duties

Import quotas

Import license and prohibition.


3) Miscellaneous Measures

Obtaining foreign loans

Development of tourism

Incentives to enhance inward remittances

Encouraging foreign investment.

Post 1991 Trade Trends

0

100000

200000

300000

400000

500000

600000

700000

1991

-92

1992

-93

1993

-94

1994

-95

1995

-96

1996

-97

1997

-98

1998

-99

1999

-200

0

2000

-01

2001

-02

2002

-03

2003

-04

2004

-05

2005

-06

Exports Imports F Invest

Movement in Foreign Exchange Reserve

International trade

Education

adam smiths

foreign exchange

production

quintal labour

exchange rate

price level

foreign trade

absolute advantage