INTERNATIONAL ECONOMICS NOTES

SHRUTI KESHARWANI B.A.6th SEM

UNIT-1

Importance of the Study of International Economics

International economics is a branch of economics that studies the flow of

goods, services, labor, capital, and currencies across countries. It examines
how nations interact economically and how such interactions affect their
growth, development, and welfare.

Key Reasons Why Studying International Economics is

Important:

1. Understanding Global Trade:

 Helps explain why countries trade goods and services.

 Studies comparative advantage—why some countries specialize in
producing certain goods.
 Provides insight into trade patterns, barriers, and agreements (like
WTO, FTAs).

2. Explains the Flow of Capital and Investments:

 Analyzes foreign direct investment (FDI), portfolio investment, and

capital mobility.
 Helps understand the role of multinational corporations and global
financial institutions.

3. Analyzing Exchange Rates and Currency Markets:

 Teaches how exchange rate systems work (fixed, floating, managed).

 Helps in understanding the foreign exchange market, currency
valuation, and currency crises.

4. Supports Economic Policy Formation:

 Guides governments in forming effective trade policies, tariff

regulations, and exchange rate policies.
  Helps in managing the balance of payments, trade deficits, and
surpluses.

5. Promotes Economic Development:

 International economics explains how international aid, trade

liberalization, and global cooperation can foster development in poor
and developing nations.

6. Evaluates the Impact of Globalization:

 Helps analyze the benefits and challenges of globalization, such as

job creation, income inequality, and environmental impact.

7. Understanding International Organizations:

 Provides knowledge of the functioning of organizations like:

o International Monetary Fund (IMF)
o World Trade Organization (WTO)
o World Bank
o United Nations Conference on Trade and Development
(UNCTAD)

8. Preparation for Careers in Global Economy:

 Essential for students and professionals entering careers in

international business, finance, diplomacy, policy-making, or
research.

Conclusion:

The study of international economics is crucial in today's interconnected

world. It equips individuals, businesses, and policymakers with the tools to
understand and effectively participate in the global economy. As international
challenges and cooperation grow, so does the relevance of this field.

Theory of Absolute Cost Advantage (by Adam Smith, 1776)

Introduction:

Adam Smith, in his landmark book "An Inquiry into the Nature and Causes of the
Wealth of Nations" (1776), introduced the Theory of Absolute Cost Advantage,
which was the first formal explanation of why international trade is beneficial for
countries.

He argued against mercantilism (which emphasized hoarding wealth and avoiding

imports), and instead promoted free trade and specialization, saying that if each
country focuses on producing goods in which it is more efficient, all trading
countries will benefit.

Definition:

A country is said to have an absolute cost advantage over another country in the
production of a good when it can produce more output using the same amount of
resources, or the same output using fewer resources or lower cost.

Core Ideas:

1. Specialization Based on Efficiency:

o Each country should produce only those goods in which it is more
efficient (has an absolute advantage).
o Countries should specialize and trade the surplus.
2. Mutual Benefit:
o Both nations benefit from trade by focusing on what they do best,
leading to increased production, efficiency, and welfare.

Assumptions of the Theory:

1. Two countries and two commodities (simplified model).

2. Labor is the only factor of production.
3. Labor is homogeneous (equal skill and productivity within a country).
4. Full employment of resources.
5. No transportation costs.
6. Free trade – no trade restrictions like tariffs or quotas.
7. Perfect competition in markets.
8. No technological differences within a country.

Numerical Example:

Let’s consider two countries: India and England

And two goods: Wheat and Cloth

The amount of labor hours required to produce one unit of each good is:
Country Wheat (hrs/unit) Cloth (hrs/unit)

India 4 6

England 8 3

 India takes fewer hours to produce Wheat → India has absolute advantage
in Wheat
 England takes fewer hours to produce Cloth → England has absolute
advantage in Cloth

According to the theory:

 India should specialize in Wheat production.

 England should specialize in Cloth production.
 They should trade with each other.
 Result: Total production increases and both benefit from trade.

Benefits of Absolute Cost Advantage:

1. Efficient Use of Resources: Countries focus on what they produce best.

2. Increased Production: Global output increases through specialization.
3. Cheaper Goods: Consumers get goods at lower prices.
4. Higher Standards of Living: Through access to a variety of goods.
5. Encourages Innovation and Growth: Due to specialization and competition.

Criticisms of the Theory:

1. Doesn’t Cover All Trade Situations:

If a country is more efficient in producing all goods (has an absolute
advantage in everything), the theory doesn’t explain why trade should still
occur.
2. Ignores Comparative Advantage:
David Ricardo later refined the theory by introducing Comparative Cost
Advantage, which shows that trade is beneficial even if one country is
better at producing both goods.
3. Unrealistic Assumptions:
o Only labor is considered (ignores capital, land, technology).
o No transport cost, full employment, and free trade are not always
true in real-world situations.
 4. No Role of Demand:
It focuses only on supply (cost), ignoring consumer preferences or demand
for goods.

Conclusion:

The Theory of Absolute Cost Advantage was a groundbreaking idea in economic

thought. It laid the foundation for free trade and specialization. While the model is
simple and has limitations, it introduced the powerful idea that international trade
can make all participating countries better off, provided they specialize in goods
they produce most efficiently.

Theory of Comparative Cost Advantage (By David Ricardo,

1817)

Introduction:

The Theory of Comparative Cost Advantage was developed by the British

economist David Ricardo in his book "Principles of Political Economy and Taxation"
published in 1817. It is considered one of the most important concepts in
international trade theory. Ricardo built upon Adam Smith’s idea of absolute
advantage, showing that even if a country has no absolute advantage in any good,
it can still benefit from trade by specializing in goods in which it has comparative
advantage.

Definition:

A country is said to have a comparative cost advantage in producing a good if it can

produce it at a lower opportunity cost compared to another country.

In other words, a country should specialize in the production of goods in which its
relative efficiency (not absolute) is higher and trade for other goods.

Core Concepts:

1. Opportunity Cost:
The value of what is foregone to produce one unit of a good.
Comparative advantage is based on comparing these opportunity costs.
2. Relative, Not Absolute Efficiency:
A country may be less efficient in producing all goods compared to another,
 but it still gains from trade if it specializes in goods where its disadvantage is
smallest.
3. Specialization and Trade:
Each country should produce and export goods in which it has a
comparative advantage, and import goods in which it has a comparative
disadvantage.

Assumptions of the Theory:

1. Two countries and two goods.

2. Labor is the only factor of production.
3. Constant returns to scale.
4. Labor is homogeneous within a country.
5. Full employment of resources.
6. No transportation costs.
7. Free trade between countries.
8. Perfect competition in both product and labor markets.

Numerical Example:

Let’s take two countries: India and England, and two goods: Wheat and Cloth.

Assume labor hours needed to produce one unit of each good:

Country Wheat (hrs/unit) Cloth (hrs/unit)

India 4 8

England 1 2

 England is more efficient in both goods (it has absolute advantage).

 But what matters here is comparative cost.

Let’s calculate opportunity cost:

 In India:
o 1 unit of Wheat costs 4 hours → Could have produced 0.5 units of
Cloth (4/8)
o 1 unit of Cloth costs 8 hours → Could have produced 2 units of
Wheat (8/4)
 In England:
 o 1 unit of Wheat costs 1 hour → Could have produced 0.5 units of
Cloth (1/2)
o 1 unit of Cloth costs 2 hours → Could have produced 2 units of
Wheat (2/1)

Now compare opportunity costs:

 India has a lower opportunity cost in producing Wheat.

 England has a lower opportunity cost in producing Cloth.

Conclusion:

 India should specialize in Wheat.

 England should specialize in Cloth.
 Through trade, both countries can consume more than they could without
trade.

Benefits of Comparative Advantage:

1. Increased Global Output:

Specialization increases efficiency and total world production.
2. Efficient Resource Allocation:
Countries focus on industries where they are relatively better.
3. Mutual Gains from Trade:
Even less productive countries benefit by trading goods they can produce at
lower opportunity cost.
4. Lower Prices and More Choices for Consumers.
5. Encouragement of Innovation:
Competition and specialization promote technological growth.

Criticisms of the Theory:

1. Unrealistic Assumptions:
o Ignores transport costs, capital, multiple goods, and economies of
scale.
o Assumes only one factor (labor) and constant opportunity cost,
which is rare.
2. Static Model:
o Does not account for changing comparative advantages over time
due to technology or investment.
3. Neglect of Structural Issues:
o Doesn’t consider income inequality, environmental damage, or
labor exploitation in developing countries.
 4. Assumes Free Trade:
o In reality, many countries impose tariffs, quotas, and trade barriers.
5. Ignores Demand Conditions:
o Only considers supply (production cost) and ignores global demand
for goods.

Conclusion:

The Theory of Comparative Cost Advantage remains a cornerstone of international

trade theory. It shows that trade is not about having the best absolute efficiency but
about relative efficiency or opportunity costs. Despite its limitations, it strongly
supports the idea that free trade leads to mutual gains, and encourages countries
to specialize based on comparative strengths.

Opportunity Cost – Definition and Detailed Explanation

Introduction:

Opportunity cost is a foundational concept in economics. It arises due to scarcity of

resources, and helps explain how individuals, firms, and governments make
decisions about how best to allocate these limited resources.

Definition:

Opportunity cost is the value of the next best alternative foregone when a choice is
made.

It shows that by choosing one option, we give up the opportunity to pursue another.

Example (Individual Level):

If a student spends time studying instead of working a job that pays ₹200 per hour,
then:

 Opportunity cost = ₹200/hour (the earnings sacrificed).

Graphical Illustration Using PPC:

The Production Possibility Curve (PPC) is used to illustrate opportunity cost when
an economy must choose between two goods.
Graph:
Good Y (Healthcare)
|
A | * ← Point A (more healthcare less education)
| /
| /
| /
| /
| /
| /
| /
|/_____________
Point B * ← Point B (more education, less healthcare)
Good X (Education)

Explanation of the Graph:

 The curve represents the maximum possible output combinations of two

goods—say, healthcare and education—using all available resources.
 Moving from point A to point B, the economy produces more education but
less healthcare.
 The opportunity cost of increasing education is the amount of healthcare
foregone.
 This trade-off occurs due to scarce resources.

Importance of Opportunity Cost:

1. Efficient Allocation:
Encourages optimal use of limited resources.
2. Better Decision-Making:
Helps evaluate what must be given up when making choices.
3. Supports Trade Decisions:
Crucial in determining comparative advantage in international trade.

Limitations:

 Hard to quantify when alternatives are intangible or long-term.

 Often subjective (depends on individual or societal preferences).

Conclusion:

Opportunity cost explains that every choice has a cost. Whether at an individual or
national level, understanding what is sacrificed helps make more rational and
efficient economic decisions. The PPC visually demonstrates this trade-off,
reinforcing how scarce resources force choices between competing needs.

Heckscher-Ohlin Theory (H-O Theory) – Definition, Features &

Explanation

Introduction:

The Heckscher-Ohlin Theory, also known as the Factor Endowment Theory, was
developed by Eli Heckscher and later expanded by Bertil Ohlin in the early 20th
century. It is a major advancement over the classical theories of Absolute
Advantage (Adam Smith) and Comparative Advantage (David Ricardo).

This theory explains why countries trade based on their factor endowments—that
is, the quantity and quality of factors of production such as labor, capital, and land.

Definition:

The Heckscher-Ohlin Theory states that a country will export goods that use its
abundant and cheap factors of production intensively, and import goods that use
its scarce and expensive factors intensively.

Core Concepts:

1. Factor Endowments:
Each country has different relative amounts of labor, capital, and land.
2. Factor Intensity:
Goods require different proportions of factors. Some are labor-intensive,
others capital-intensive.
3. Specialization Based on Factor Availability:
Countries should specialize in producing and exporting goods that use their
abundant factors more intensively.

Features of the Heckscher-Ohlin Theory:

1. Two-Factor Model:
The theory assumes two factors of production: labor and capital.
2. Two-Goods and Two-Countries Assumption:
For simplicity, it considers two countries, each producing two goods.
 3. Difference in Factor Endowments:
Countries differ in their supply of labor and capital.
4. Difference in Factor Intensities:
Goods differ in the extent to which they require labor or capital to produce.
5. Perfect Competition:
Markets for goods and factors are competitive in both countries.
6. Identical Technology and Tastes:
Assumes both countries have access to the same technology and
preferences.
7. No Transportation Costs or Trade Barriers.
8. Trade Leads to Factor Price Equalization:
Free trade leads to equalization of wages and returns to capital across
countries.

Graphical Representation (Edgeworth Box or Diagram):

While the Heckscher-Ohlin model is usually explained with a box diagram, for
simplicity, we can illustrate the idea through a basic comparative production model.

Assume:

 Country A is labor-abundant.
 Country B is capital-abundant.
 Two goods: Clothing (labor-intensive) and Machinery (capital-intensive).
Production Possibility Frontiers (PPFs):

Country A (Labor-abundant):
Clothing
|
| *
| /
| /
| /
| /
| /
|/_____________ Machinery

Country B (Capital-abundant):
Clothing
|
| *
| /
| /
| /
| /
| /
|___/__________ Machinery

 Country A specializes in Clothing (labor-intensive).

 Country B specializes in Machinery (capital-intensive).

Result: Each country exports the good that uses its abundant factor, and imports
the one that uses its scarce factor.

Implications of the H-O Theory:

1. Explains Trade Patterns:

Countries trade not just due to differences in productivity but due to
differences in factor endowments.
2. Wage and Capital Return Effects:
Trade affects factor prices—labor wages rise in labor-abundant countries,
and returns on capital rise in capital-abundant countries.
3. Foundation for Factor Price Equalization Theorem:
Free trade leads to equalization of factor prices across countries.

Criticisms of the H-O Theory:

1. Leontief Paradox:
Empirical evidence by Wassily Leontief showed that the U.S. (a capital-
 abundant country) was exporting labor-intensive goods and importing
capital-intensive goods—contradicting the theory.
2. Assumes Identical Technology:
In reality, technology varies across countries, affecting productivity.
3. Ignores Economies of Scale:
Doesn’t account for increasing returns to scale or learning by doing.
4. Over-simplified Assumptions:
Real-world trade involves many countries, goods, and factors (like land,
entrepreneurship, human capital).

Conclusion:

The Heckscher-Ohlin Theory remains a cornerstone of modern international trade

theory. It provides a strong theoretical framework to explain trade patterns based
on resource availability and cost differences. Despite its limitations and challenges
(like the Leontief Paradox), it has significantly influenced both trade policy and
empirical research in economics.
 UNIT-2
Trade as an Engine of Economic Growth – Definition and
Explanation

Definition:

The phrase “trade as an engine of growth” refers to the idea that international
trade plays a crucial role in driving and accelerating the economic growth of a
country by promoting efficient resource allocation, technological advancement,
increased productivity, and access to larger markets.

The concept suggests that countries that are more open to trade tend to grow faster
than those that follow protectionist policies.

Origin of the Concept:

The idea of trade as a growth engine gained prominence with classical economists
such as Adam Smith and David Ricardo, and was further developed in the post-
World War II period by economists like Gunnar Myrdal, Paul Samuelson, and
Jagdish Bhagwati. The experiences of export-led economies like Japan, South
Korea, and later China provided empirical support to this view.

How Trade Promotes Growth:

1. Access to Larger Markets:

Trade allows countries to sell goods and services beyond their domestic
markets, leading to higher production and income.
2. Economies of Scale:
Producers can expand operations and reduce per-unit costs when selling to
international markets.
3. Technology Transfer and Innovation:
Openness to trade exposes domestic firms to foreign technologies,
products, and best practices, spurring innovation.
4. Efficient Resource Allocation:
Trade encourages countries to specialize in the production of goods and
services in which they have a comparative advantage, leading to higher
productivity.
 5. Foreign Investment:
Trade openness often attracts foreign direct investment (FDI), which brings
capital, skills, and infrastructure development.
6. Improved Competition and Quality:
International trade increases competition, which leads to better quality
products, lower prices, and innovation.
7. Employment Generation:
Export-oriented industries create more job opportunities and higher wages,
contributing to poverty reduction.

Theoretical Support:

 Classical Theory (Ricardo): Specialization and comparative advantage lead

to increased output.
 Heckscher-Ohlin Theory: Trade reflects differences in factor endowments
and leads to more efficient global production.
 New Growth Theory: Trade encourages investment in R&D, human capital,
and knowledge spillovers.

Real-World Examples:

 East Asian Tigers (South Korea, Taiwan, Singapore, Hong Kong): Rapid
growth through export-oriented industrialization.
 China and India: Significant growth acceleration after liberalizing trade
policies in the 1980s and 1990s.
 Germany and Japan: Post-war reconstruction and sustained growth fueled
by strong export performance.

Criticisms and Limitations:

1. Unequal Gains:
Benefits of trade are not always evenly distributed; some sectors or workers
may lose.
2. Dependency and Vulnerability:
Over-reliance on exports can make economies vulnerable to global market
fluctuations.
3. Environmental Concerns:
Increased production for trade may lead to resource depletion and
pollution.
4. Terms of Trade Deterioration:
Developing countries exporting primary goods may face declining terms of
trade over time.
 5. Neglect of Domestic Industries:
Sudden trade liberalization can harm infant industries that are not yet
competitive.

Conclusion:

Trade can indeed act as a powerful engine of growth, particularly when supported
by sound macroeconomic policies, investment in human capital, and infrastructure.
However, to maximize the benefits of trade and minimize its adverse effects,
governments must adopt complementary policies such as social safety nets, skill
development, and environmental regulations. When managed well, trade has the
potential to transform economies, reduce poverty, and drive sustainable
development.

Import Substitution vs. Export Orientation

1. Introduction:

Import Substitution and Export Orientation are two distinct trade and industrial
strategies adopted by countries to achieve economic growth, industrial
development, and self-reliance. Both have been implemented at different stages by
developing economies, often reflecting their development goals and global
economic conditions.

2. Definitions:

Import Substitution Industrialization (ISI):

Import Substitution is a trade strategy that promotes domestic production of goods

that were previously imported, with the aim of reducing foreign dependency.

It encourages the development of local industries by imposing high tariffs or import

restrictions on foreign goods, thus protecting domestic producers.

Export Orientation (or Export-Led Growth):

Export Orientation is a trade strategy that emphasizes producing goods for

international markets rather than just for domestic consumption.
It encourages industries to become competitive globally and to earn foreign
exchange by integrating into the global economy through trade liberalization and
market-driven policies.

3. Key Differences:

Aspect Import Substitution (ISI) Export Orientation (EO)

Reduce imports and promote Increase exports and integrate

Objective
self-reliance with global trade

Tariffs, quotas, subsidies to Trade liberalization, incentives for

Policy Tools
local industries exporters

Focus Domestic market International market

Role of High – planning, protection, Facilitator – improving

Government subsidies competitiveness

Industry Type Often heavy industries,

Competitive, exportable sectors
Promoted consumer goods

India (1950s–80s), Latin South Korea, Tai wan, China

Examples
America (post-1980s)

Initial growth but inefficiency Rapid industrial growth and

Result (Generally)
and stagnation foreign exchange

4. Features of Import Substitution:

 Focus on self-sufficiency.
 Protective barriers against imports (tariffs/quotas).
 Promotion of infant industries.
 Heavy involvement of the public sector.
 Often leads to limited competition and low efficiency.

5. Features of Export Orientation:

 Integration with global markets.

 Emphasis on comparative advantage.
 Competitive and market-driven production.
  Encourages foreign investment and technology transfer.
 More employment opportunities and foreign exchange earnings.

6. Real-World Examples:

 India followed Import Substitution from the 1950s to the early 1990s. After
liberalization in 1991, it moved toward an export-oriented model.
 East Asian Tigers (South Korea, Taiwan, Singapore) adopted export-led
strategies in the 1960s–80s and witnessed rapid industrial growth.
 Latin American countries like Brazil and Argentina initially relied on ISI,
which led to inefficiencies and debt crises.

7. Advantages and Disadvantages:

Import Substitution:

Advantages:

 Builds domestic capacity

 Reduces dependency on imports
 Protects local employment

Disadvantages:

 Encourages inefficiency and low productivity

 Limits foreign competition and innovation
 May cause trade deficits in the long run

Export Orientation:

Advantages:

 Encourages efficiency and global competitiveness

 Generates foreign exchange
 Leads to rapid industrialization

Disadvantages:

 Vulnerable to global market shocks

 May neglect domestic market needs
 Requires strong infrastructure and institutions
8. Conclusion:

Both Import Substitution and Export Orientation have played vital roles in the
economic development strategies of various countries. While ISI may be suitable in
early stages to develop domestic capacity, export orientation has proven more
effective in sustaining long-term economic growth by embracing global trade,
competition, and innovation. Today, most successful economies strike a balance
between protecting strategic sectors and competing in the global marketplace.

Export-Led Growth – Definition and Explanation

Definition:
Export-led growth is an economic development strategy whereby a country seeks to
accelerate its growth by promoting and expanding exports of goods and services.
Under this model, domestic industries focus on producing for foreign markets,
leveraging comparative advantages to earn foreign exchange, achieve economies of
scale, and stimulate domestic investment and employment.

Key Features:

1. Market Orientation:
Domestic firms orient production toward overseas demand rather than
solely the home market.
2. Trade Liberalization:
Reduction of export controls, lower tariffs on intermediate inputs, and
streamlined customs procedures to make exporters competitive.
3. Policy Support:
Governments may offer export incentives (subsidies, tax breaks), establish
special export-processing zones, and invest in infrastructure (ports, roads,
communications).
4. Foreign Exchange Earnings:
Export revenues finance imports of capital goods, technology, and raw
materials, fostering further industrialization.
5. Economies of Scale and Learning-by-Doing:
Serving larger international markets allows firms to expand output, lower
unit costs, and upgrade technology and skills.
6. Attraction of FDI:
A strong export orientation can draw foreign direct investment seeking to
locate production close to export hubs.

Examples of Export-Led Growth:

  East Asian Tigers (South Korea, Taiwan, Singapore, Hong Kong): Rapid
industrialization in the 1960s–1990s through textiles, electronics, and
shipbuilding.
 China post-1978 reforms: Emergence as “the world’s factory” in
manufactured goods, propelled by Special Economic Zones.

Developing Countries – Definition and Characteristics

Definition:
Developing countries are nations characterized by lower levels of per capita
income, industrialization, and human development indicators compared to
advanced economies. They are in the process of industrial, social, and institutional
transformation aimed at achieving sustained growth, poverty reduction, and
improved living standards.

Key Characteristics:

1. Income Levels:
Low to middle per capita GDP relative to global averages.
2. Structural Transformation:
Economy shifting from agriculture-based to industry- and service-based
sectors.
3. Human Development Gaps:
Lower literacy rates, higher infant mortality, and shorter life expectancy as
measured by the Human Development Index (HDI).
4. Infrastructure Deficits:
Inadequate transport, power, water, and digital connectivity impede
productivity.
5. Institutional Challenges:
Weaker governance, regulatory frameworks, and financial markets slow
investment and growth.
6. High Unemployment and Informal Sector:
Large informal economies and underemployment in urban and rural areas.
7. External Vulnerabilities:
Dependence on commodity exports, volatile terms of trade, and exposure
to external shocks.

Classification Examples:
  Low-Income Countries (LICs): Per capita GNI of $1,085 or less (World Bank,
FY 2024).
 Lower-Middle-Income Countries (LMICs): Per capita GNI of $1,086–$4,255.
 Upper-Middle-Income Countries (UMICs): Per capita GNI of $4,256–
$13,205.

Link Between Export-Led Growth and Developing Countries

Many developing countries adopt export-led strategies to:

 Accelerate industrialization by tapping into global demand.

 Earn foreign exchange to finance imports of technology and capital goods.
 Generate employment and increase household incomes.
 Spur structural change toward higher-value manufacturing and services.

When successfully implemented—with complementary policies in education,

infrastructure, and institutions—export-led growth can be a powerful engine for the
economic transformation of developing nations.

Concept of Terms of Trade (ToT)

Definition:

Terms of Trade (ToT) refer to the rate at which one country's goods exchange for
the goods of another country in international trade. It is usually expressed as the
ratio of export prices to import prices.

In simple terms, ToT measure how much a country can import for a given unit of
its exports. It reflects the relative prices of exports and imports and helps assess the
gain or loss from trade.

Formula:

Terms of Trade (ToT)=(Index of Export Prices/Index of Import Prices)×100

 If ToT > 100 → Favourable ToT (country gets more imports for its exports)
 If ToT < 100 → Unfavourable ToT (country pays more for imports than it
earns from exports)

Example:
  Suppose the export price index is 120 and the import price index is 100.

ToT=(120/100)×100=120

This means the country's terms of trade are favourable — it can import more goods
for every unit of goods it exports.

Types of Terms of Trade:

1. Net Barter Terms of Trade (NBTT):

Ratio of export prices to import prices (as defined above).
2. Gross Barter Terms of Trade:
Ratio of quantity of imports to quantity of exports.
3. Income Terms of Trade:
NBTT × Volume of exports. It shows the country’s capacity to import.
4. Single Factoral Terms of Trade:
Takes into account productivity of factors in the export sector.

Factors Affecting Terms of Trade:

1. Changes in global prices of exports and imports

2. Exchange rate fluctuations
3. Tariffs and trade barriers
4. Technological advancements
5. Supply and demand in international markets
6. Inflation differentials between trading partners

Importance of Terms of Trade:

 Indicates the economic strength in trade relationships.

 Helps in evaluating the gain or loss from international trade.
 Guides policy decisions on tariffs, exchange rates, and trade negotiations.
 Assists in balance of payments analysis.
 Crucial for developing countries reliant on primary goods exports, which
often face deteriorating ToT.

Conclusion:

The concept of Terms of Trade is vital in international economics as it directly

influences a country's purchasing power in global markets. A favourable ToT
improves the welfare of a nation by allowing more imports for the same amount of
exports, while an unfavourable ToT can worsen the trade balance and reduce
national income. Monitoring ToT is essential for designing sound trade and
economic policies.
 UNIT-3

What is Foreign Exchange?

Foreign Exchange (Forex or FX) refers to the global system through which
currencies of different countries are bought, sold, and exchanged. It is
essential for facilitating international trade, investment, travel, and financial
transactions. Foreign exchange allows one country to trade with another using
a common value – currency.

Key Concepts Related to Foreign Exchange:

1. Foreign Exchange Market (Forex Market):

 It is a decentralized global market where currencies are traded.

 It is the largest and most liquid financial market in the world,
operating 24 hours a day, five days a week.
 Participants include banks, governments, central banks, corporations,
investment firms, and individual traders.

2. Foreign Exchange Rate:

 This is the rate at which one currency is exchanged for another.

 Example: If 1 USD = 83 INR, it means you need 83 Indian Rupees to
buy 1 US Dollar.
 Exchange rates are influenced by factors like:
o Interest rates
o Inflation
o Political stability
o Economic performance
o Market speculation

3. Types of Exchange Rate Systems:

 Fixed Exchange Rate: The currency's value is tied to another major

currency (e.g., US dollar or gold).
 Floating Exchange Rate: Determined by market forces (supply and
demand).
 Managed Float: A mix of both, where a country's central bank may
intervene to stabilize or direct the currency's value.
4. Foreign Exchange Reserves:

 These are assets held by a country's central bank, usually in the

form of foreign currencies.
 Used to stabilize the local currency, pay international debts, and
handle economic crises.

Functions of Foreign Exchange:

1. Facilitates International Trade:

o Enables countries to import and export goods and services.
o Foreign currencies are exchanged to settle payments between
buyers and sellers in different countries.
2. Supports Foreign Investment:
o Investors can invest in foreign stocks, bonds, and real estate by
converting currencies.
3. Maintains Balance of Payments:
o Foreign exchange transactions are recorded in the balance of
payments of a country, reflecting its economic transactions
with the rest of the world.
4. Hedging and Speculation:
o Businesses use forex to hedge against currency risks.
o Traders speculate on currency movements to earn profits.

Participants in the Foreign Exchange Market:

1. Commercial Banks
2. Central Banks (e.g., Reserve Bank of India)
3. Foreign Exchange Brokers
4. Multinational Corporations
5. Governments
6. Individual Traders and Investors

Importance of Foreign Exchange in India:

 Helps in managing imports and exports effectively.

 Plays a crucial role in attracting foreign direct investment (FDI).
 Allows remittances from Indians working abroad to flow into the
Indian economy.
  Helps the Reserve Bank of India (RBI) manage the rupee's value and
maintain economic stability.

Conclusion:

Foreign exchange is the lifeline of global commerce and finance. It ensures

that nations can interact economically despite having different currencies. By
understanding how foreign exchange works, we gain insights into global trade
dynamics, currency fluctuations, and economic stability.

Let me know if you'd like examples, charts, or explanations on any specific

aspect (like exchange rate systems or India's foreign exchange policy).

Exchange Rate Determination

An exchange rate is the price of one country’s currency in terms of another. For
example, if 1 USD = ₹83, it means one US dollar can be exchanged for 83 Indian
rupees.

Two major theories explain how exchange rates are determined:

1. Purchasing Power Parity (PPP) Theory

Definition:

The Purchasing Power Parity (PPP) theory states that exchange rates between two
countries should be in equilibrium when their purchasing power is the same in both
countries. That is, a basket of identical goods should cost the same in both countries
when measured in a common currency.

Absolute PPP Formula:

E=P1P2E = \frac{P_1}{P_2}E=P2P1

Where:

 EEE = Exchange rate (domestic currency per unit of foreign currency)

 P1P_1P1 = Price level in the domestic country
 P2P_2P2 = Price level in the foreign country
Example:
If a basket of goods costs ₹8,300 in India and $100 in the USA:

E=8300100=₹83/$E = \frac{8300}{100} = ₹83/\$E=1008300=₹83/$

This means the PPP exchange rate is ₹83 per dollar.

Relative PPP Formula:

Relative PPP explains changes in exchange rate based on inflation differentials:

E1−E0E0≈πd−πf\frac{E_1 - E_0}{E_0} \approx \pi_d - \pi_fE0E1−E0≈πd−πf

Where:

 E0E_0E0 = Initial exchange rate

 E1E_1E1 = New exchange rate
 πd\pi_dπd = Domestic inflation rate
 πf\pi_fπf = Foreign inflation rate

If inflation is higher in the domestic country, the domestic currency is expected to

depreciate.

Assumptions of PPP Theory:

 No transportation costs or tariffs

 Free trade of goods
 Identical goods in both countries
 No government intervention in exchange markets

Limitations:

 Not valid in short run due to market frictions

 Not all goods are tradable (e.g., services)
 Speculation and capital flows also affect exchange rates
 Trade barriers and taxes distort real prices

2. Demand and Supply Theory of Exchange Rate (Flexible

Exchange Rate)

Definition:
Under this theory, the exchange rate is determined by the interaction of the
demand and supply of foreign exchange in the foreign exchange market.

Demand for Foreign Exchange Arises From:

 Imports of goods and services

 Investment abroad (FDI, portfolio)
 Foreign travel and education
 Debt repayments

Supply of Foreign Exchange Comes From:

 Exports of goods and services

 Foreign investment inflows
 Tourism earnings
 Remittances from abroad

Equilibrium Exchange Rate:

It is determined at the point where demand for foreign exchange equals the
supply.

Graphical Representation:
Exchange Rate (₹/$)
↑
| S (Supply of $)
| /
| /
| /
| /
| /
|_____/___________ D (Demand for $)
→ Quantity of $

 At the intersection of demand and supply curves, the equilibrium exchange

rate is established.
 If demand for foreign currency increases (e.g., due to higher imports), the
exchange rate rises (domestic currency depreciates).
 If supply of foreign currency increases (e.g., due to higher exports), the
exchange rate falls (domestic currency appreciates).
Factors Affecting Demand and Supply of Foreign Exchange:

Factor Effect on Exchange Rate

Increase in imports Increases demand for foreign currency → depreciation

Increase in exports Increases supply of foreign currency → appreciation

Capital inflows (FDI/FII) Increases foreign currency supply → appreciation

Capital outflows Increases foreign currency demand → depreciation

Domestic inflation Reduces competitiveness → depreciation

High interest rates (domestic) Attract capital inflow → appreciation

Comparison of PPP Theory and Demand-Supply Theory

Criteria PPP Theory Demand-Supply Theory

Relative price levels Market demand and supply

Basis
(purchasing power) of forex

Time Frame Long run Short run and medium term

Consideration of Capital
No Yes
Flows

Based on capital, trade,

Price Movements Based on goods prices
speculation

More practical and

Realism Theoretical
applicable
Conclusion:

 The PPP theory provides a long-term theoretical benchmark for exchange

rate based on inflation and price level comparisons.
 The Demand-Supply theory explains how exchange rates are determined in
real-time through actual market forces.
 In reality, both theories interact, and exchange rates are also influenced by
other factors such as interest rates, monetary policy, political stability, and
speculation.

Here is a clear and detailed explanation of the Concepts and Components of

Balance of Trade (BoT) — suitable for academic writing, assignments, and
exams.

Balance of Trade (BoT)

Definition:

The Balance of Trade refers to the difference between the value of a

country's exports and imports of visible goods (merchandise goods) over a
specific period, usually one year.

Balance of Trade (BoT)=Exports of Goods−Imports of Goods

 If exports > imports, the country has a trade surplus (favorable

BoT).
 If imports > exports, the country has a trade deficit (unfavorable
BoT).

Concepts Related to Balance of Trade:

1. Visible Items:

 These include tangible goods that are physically traded across

borders.
 Examples: machinery, food products, crude oil, electronics, textiles.

BoT only includes visible items — it excludes services, which are part of the
current account in the Balance of Payments (BoP).
2. Trade Surplus:

 When the value of exports exceeds imports, it indicates a surplus.

 It reflects strong foreign demand and a competitive domestic
industry.

3. Trade Deficit:

 When the value of imports exceeds exports, it results in a deficit.

 It may reflect heavy dependence on foreign goods or low export
competitiveness.

Components of Balance of Trade:

Component Explanation

Exports of Total value of goods sold to other countries (e.g., iron ore, software
Goods hardware, etc.)

Imports of Total value of goods bought from other countries (e.g., petroleum,
Goods gold, electronics)

Net Exports Difference between exports and imports (i.e., BoT)

Example:

Suppose during 2024–25:

 India exported goods worth $400 billion

 Imported goods worth $650 billion

Then:

BoT= 400−650 = −250 billion

This represents a trade deficit of $250 billion.

Significance of Balance of Trade:

1. Indicator of Economic Health:

 oSurplus may reflect a strong industrial sector.
oDeficit may suggest excessive foreign dependence.
2. Impact on Currency:
o Persistent deficit may put downward pressure on the
domestic currency.
3. Link to Balance of Payments (BoP):
o BoT is a major component of the current account of the
BoP.
4. Policy Implications:
o A high deficit may lead governments to promote import
substitution or export promotion.

Difference Between BoT and BoP:

Feature Balance of Trade (BoT) Balance of Payments (BoP)

Only includes visible goods Includes goods, services,

Scope
(merchandise) income, capital

Broader account including

Subset of Part of Current Account in BoP
capital flows

Type of All international economic

Export and import of goods
Transactions transactions

Balance of Payments (BoP)

Definition:

The Balance of Payments (BoP) is a systematic record of all economic transactions

between the residents of a country and the rest of the world during a given period,
usually one financial year.

These transactions include:

 Trade in goods and services

 Transfer payments
 Capital flows
 Foreign exchange reserves
The BoP reflects how a country earns and spends foreign exchange and helps in
assessing its economic position in the global context.

Key Concept:
BoP=Current Account+Capital Account+Errors and Omissions+ΔForeign Exchange Re
serves\text{BoP} = \text{Current Account} + \text{Capital Account} + \text{Errors
and Omissions} + \Delta \text{Foreign Exchange
Reserves}BoP=Current Account+Capital Account+Errors and Omissions+ΔForeign Exc
hange Reserves

By accounting identity, BoP should always balance, though individual components

may show a surplus or deficit.

Main Components of Balance of Payments:

The BoP has two major components:

1. Current Account

The current account records the flow of goods, services, income, and transfers
between a country and the rest of the world.

Components:

Sub-component Description

a. Balance of Trade Exports – Imports of visible goods (merchandise trade)

b. Invisibles/Services Includes transport, travel, IT services, financial services, etc.

Income earned from abroad (dividends, interest, salaries)

c. Income
and paid to foreigners

Unilateral transfers such as foreign aid, remittances, gifts,

d. Current Transfers
etc.

A surplus in the current account means the country is earning more from the world
than it is spending.
2. Capital Account

The capital account records all international capital transfers and the
acquisition/disposal of non-financial assets.

This account is relatively small and includes:

Sub-component Description

Debt forgiveness, transfer of assets by

a. Capital transfers
migrants, etc.

b. Sale/purchase of non-produced, non-

Includes patents, trademarks, etc.
financial assets

3. Financial Account (Often grouped with Capital Account in

India)

This records investments and borrowings between the country and the rest of the
world.

Components:

Sub-component Description

a. FDI (Foreign Direct Investment) Long-term investment in business enterprises

b. FPI (Foreign Portfolio

Investment in stocks, bonds, etc.
Investment)

External borrowings by government and private

c. Loans
sector

d. Banking Capital Movements of foreign currency, deposits, etc.

A financial account surplus means more capital is coming into the country than
going out.

4. Errors and Omissions

  Balancing item to adjust for unrecorded or misrecorded transactions.
 Ensures the BoP identity balances exactly.

5. Change in Foreign Exchange Reserves (Official Reserves

Account)

 Reflects the buying or selling of foreign exchange by the central bank (e.g.,
RBI in India).
 Used to manage exchange rate and maintain external stability.

Summary Table: Components of BoP

Account Type Main Items Included Nature of Transactions

Goods, services, income, current

Current Account Day-to-day transactions
transfers

Capital Account Capital transfers, non-produced assets One-time transfers

Financial Account FDI, FPI, loans, banking capital Investment and borrowing

Errors &
Statistical discrepancies Adjustment factor
Omissions

Foreign exchange holdings of central Monetary management

Reserves
bank tool

Balance of Payments Surplus or Deficit:

 A BoP surplus means the inflow of foreign currency exceeds the outflow.
 A BoP deficit implies the country is spending more foreign exchange than it
earns.
 Central banks may intervene to maintain stability by using foreign reserves.

Significance of Balance of Payments:

1. Indicates economic health in the global context.

2. Helps in policy formulation related to trade, capital flows, and foreign
exchange.
3. Affects exchange rate stability.
4. Shows whether a country is a net borrower or lender to the rest of the
world.
 5. Helps attract foreign investors by indicating macroeconomic stability.

Difference Between BoT and BoP:

Criteria Balance of Trade (BoT) Balance of Payments (BoP)

Only exports and imports of Includes goods, services, transfers,

Scope
goods capital

A component of the current

Part of Broader accounting record
account

Comprehensive record of international

Nature Narrow in scope
dealings

Balances
May show surplus or deficit Must always balance overall
Always?

Consequences of Disequilibrium in Balance of Payments

When a country experiences a disequilibrium in its Balance of Payments—meaning

its foreign exchange inflows do not match outflows—it can face several economic
consequences, both short-term and long-term. These consequences affect the
country’s currency value, economic stability, and international credibility.

1. Pressure on Exchange Rates

 Currency Depreciation:
Persistent BoP deficits lead to increased demand for foreign currency to pay
for imports and debt, causing the domestic currency to lose value relative to
foreign currencies.
 Currency Volatility:
Fluctuating BoP positions cause unstable exchange rates, which create
uncertainty for businesses engaged in international trade.

2. Depletion of Foreign Exchange Reserves

  To maintain the fixed exchange rate or to stabilize the currency, a country
uses its foreign exchange reserves to meet excess demand for foreign
currency.
 Continuous BoP deficits can drain reserves, reducing the country’s ability to
intervene in currency markets and pay for essential imports (e.g., fuel,
medicine).

3. Inflationary Pressures

 Currency depreciation increases the cost of imported goods and raw

materials, leading to higher domestic prices.
 Inflation reduces purchasing power, raises the cost of living, and may affect
economic growth adversely.

4. Restrictive Trade and Economic Policies

 To correct disequilibrium, governments may impose import restrictions,

tariffs, and quotas to reduce import demand.
 Such policies may lead to reduced availability of essential goods and affect
consumer welfare.
 Export promotion measures and currency devaluation may be undertaken
but can have mixed short-term effects.

5. Increased External Borrowing and Debt Burden

 To finance persistent BoP deficits, countries may borrow from international

financial institutions or foreign governments.
 This can increase the external debt burden, resulting in higher future debt
servicing costs and reduced fiscal space for development.

6. Loss of Investor Confidence

 Continuous BoP problems signal economic instability, leading to reduced

foreign investment.
 Capital flight may occur as investors withdraw funds, worsening the BoP
position and economic outlook.

7. Impact on Economic Growth

 Disequilibrium can disrupt trade and investment flows, leading to slower

economic growth or even recession.
  Uncertainty in foreign exchange markets discourages long-term planning by
businesses.

8. Possible International Intervention

 Persistent disequilibrium may prompt intervention by international

organizations like the International Monetary Fund (IMF).
 Countries may have to adopt austerity measures or structural adjustment
programs that can cause social and economic hardships.

Measures to Correct Deficit in the Balance of Payments

A deficit in the Balance of Payments means that a country's foreign exchange

outflows exceed inflows, leading to economic instability. To restore equilibrium,
countries adopt a combination of policy measures aimed at reducing imports,
boosting exports, attracting capital inflows, or adjusting currency values.

1. Exchange Rate Adjustment (Devaluation/Depreciation)

 Devaluation (in fixed exchange rate systems) or depreciation (in flexible

systems) makes the domestic currency weaker relative to foreign
currencies.
 This makes exports cheaper and more competitive internationally and
imports more expensive, helping to reduce the trade deficit.
 It encourages foreign buyers to purchase more domestic goods and
discourages domestic consumers from buying foreign goods.

2. Trade Policy Measures

 Import Restrictions: Governments may impose tariffs, quotas, or bans on

non-essential or luxury imports to reduce foreign exchange outflows.
 Export Promotion: Incentives such as subsidies, tax rebates, or export
credits encourage domestic producers to increase exports.
 Diversification of Exports: Encouraging production of a wider range of
exportable goods to reduce dependence on a few products.

3. Monetary Policy

 Tightening monetary policy by raising interest rates can reduce domestic

consumption and imports by lowering demand.
 Higher interest rates may also attract foreign capital inflows seeking better
returns.
  However, tight monetary policy must be balanced to avoid harming
economic growth.

4. Fiscal Policy

 Reducing government spending and increasing taxes (austerity measures)

can reduce domestic demand and imports.
 Fiscal discipline helps control inflation and stabilizes the currency.
 Governments may redirect spending towards export-oriented sectors.

5. Encouraging Foreign Investment

 Attracting Foreign Direct Investment (FDI) and Foreign Portfolio

Investment (FPI) can bring in foreign exchange and finance the deficit.
 Improving the business environment, simplifying regulations, and offering
incentives can help attract foreign capital.

6. Export Credit and Marketing Assistance

 Providing financial assistance, export credits, and improving export

infrastructure (ports, logistics) helps domestic firms compete globally.
 Government agencies may assist in finding new markets and buyers.

7. Structural Reforms

 Improving productivity and competitiveness through reforms in labor

markets, technology adoption, and infrastructure development.
 Enhancing quality and value addition in exports to increase foreign
exchange earnings.

8. Control of Capital Outflows

 Imposing restrictions or regulations on capital flight to prevent foreign

exchange from leaving the country unnecessarily.
 Encouraging repatriation of profits and dividends by foreign firms.

9. Bilateral and Multilateral Aid or Loans

 Temporary inflows of foreign exchange through loans or aid from

international organizations like the IMF or World Bank.
 These funds can help stabilize reserves while structural adjustments take
effect.
 UNIT-4
Free Trade: Definition and Explanation

Definition:
Free trade is an economic policy and international trade practice where
goods and services can be exchanged between countries without any
government-imposed restrictions such as tariffs, quotas, or subsidies.

In a free trade system, markets operate with minimal interference, and

trade is driven by the principle of comparative advantage—where countries
produce and export goods they are most efficient at, and import those they are
less efficient at producing.

Key Features of Free Trade:

1. No Tariffs or Duties:
o No taxes are imposed on imports or exports.
o This makes foreign goods cheaper and promotes trade volume.
2. No Quotas or Restrictions:
o There are no limitations on the quantity of goods imported or
exported.
3. Market-Driven Prices:
o Prices of traded goods and services are determined by global
supply and demand, not government controls.
4. Unrestricted Access to Markets:
o Producers and consumers have access to international markets
without artificial barriers.
5. Promotes Competition and Efficiency:
o Domestic firms face competition from foreign companies,
which encourages innovation and lower prices.

Advantages of Free Trade:

Benefit Description

Efficient Resource Countries specialize in what they produce best, maximizing

Allocation global efficiency.

Imports may be cheaper than domestically produced

Lower Consumer Prices
goods.

Increased Variety of Consumers get access to a wider range of products and

Goods services.

Export-oriented production can lead to job creation and

Economic Growth
higher GDP.
 Benefit Description

Technology Transfer Trade facilitates the flow of new technologies and ideas.

Disadvantages of Free Trade:

Limitation Description

Domestic Industry Local industries may suffer due to international

Exposure competition.

Certain sectors may lose employment as production shifts

Job Losses
globally.

Some countries may face deficits if imports consistently

Trade Imbalances
exceed exports.

Exploitation of Developing countries may overuse resources to meet

Resources export demands.

Gains from trade may be unequally distributed among and

Unequal Benefits
within countries.

Examples of Free Trade Agreements (FTAs):

 WTO (World Trade Organization): Promotes global trade

liberalization.
 NAFTA/USMCA: Free trade among the USA, Canada, and Mexico.
 EU Single Market: Free movement of goods, services, capital, and
labor within EU nations.
 India-ASEAN FTA: Promotes trade between India and Southeast
Asian nations.

Conclusion:

Free trade supports economic integration, global cooperation, and

consumer welfare, but it also requires policy mechanisms to protect
vulnerable industries and ensure fair competition. While it offers many
benefits, balanced and regulated trade is often more realistic for sustainable
development, especially in developing countries.
Protection Trade / Protectionism: Definition and Explanation

Definition:

Protectionism refers to an economic policy where a country restricts imports and

sometimes encourages exports through various government measures like tariffs,
quotas, subsidies, and regulations to protect domestic industries from foreign
competition.

The goal is to safeguard local jobs, industries, and economies from the adverse
effects of unrestricted international trade, especially when domestic producers are
less competitive.

Key Features of Protection Trade:

1. Tariffs (Import Duties):

o Taxes imposed on imported goods to make them more expensive
than local products.
2. Import Quotas:
o Limits on the quantity of a particular good that can be imported into
the country.
3. Subsidies to Domestic Industries:
o Financial support from the government to local businesses to help
them compete with foreign producers.
4. Non-Tariff Barriers (NTBs):
o Indirect restrictions like strict product standards, licensing, and
administrative delays.
5. Exchange Controls:
o Restrictions on the availability and convertibility of foreign exchange
to limit imports.

Objectives of Protectionism:

 To protect infant industries that are not yet strong enough to face foreign
competition.
 To preserve jobs in domestic industries.
 To maintain national security, especially in strategic sectors (e.g., defense,
agriculture).
 To correct trade imbalances (reduce import surpluses).
 To prevent dumping, where foreign companies sell goods below cost to
dominate the market.
Advantages of Protectionism:
Benefit Description

Protects Domestic Prevents local businesses from being driven out by

Industries cheaper imports.

Reduces job losses in sectors vulnerable to foreign

Preserves Employment
competition.

Promotes development of domestic industries and

Encourages Self-Reliance
reduces import dependency.

Shields the economy from artificially low-priced foreign

Prevents Dumping
goods.

Supports Government
Tariffs provide income to the government.
Revenue

Disadvantages of Protectionism:
Limitation Description

Higher Prices for

Tariffs and import restrictions raise prices of goods.
Consumers

Limited Variety of Goods Consumers have fewer choices due to reduced imports.

Inefficiency and Domestic industries may not innovate or improve

Complacency without competition.

Retaliation from Other Other countries may impose their own tariffs, leading to
Countries trade wars.

Artificial support may lead to overproduction or

Distorted Market Signals
misallocation of resources.

Examples of Protectionist Measures in Practice:

 India's import restrictions on Chinese electronics and toys.

 U.S. tariffs on steel and aluminum to protect domestic manufacturing.
  European Union’s Common Agricultural Policy (CAP) which subsidizes EU
farmers.

Conclusion:

Protection trade policies can be useful in supporting domestic industries, especially

in the early stages of development or during economic crises. However, long-term
and excessive protectionism can lead to inefficiency, high consumer prices, and
trade retaliation. Most countries today follow a mixed approach, using selective
protectionism alongside free trade policies.

TARIFF: Definition and Explanation

Definition:

A tariff is a tax imposed by a government on goods and services imported from

other countries. Sometimes, tariffs are also applied to exports, but most commonly,
they are used to make imported goods more expensive than locally produced ones,
thereby protecting domestic industries from foreign competition.

Tariffs are one of the oldest and most commonly used tools in protectionist trade
policy.

Types of Tariffs:
Type Description

1. Ad-Valorem A percentage of the value of the imported good (e.g., 10% of the
Tariff product’s value).

A fixed amount charged per unit of the good (e.g., ₹100 per
2. Specific Tariff
imported smartphone).

3. Compound A combination of ad-valorem and specific tariffs (e.g., 5% of value

Tariff + ₹50 per unit).
Objectives of Imposing Tariffs:

1. Protect Domestic Industries:

o Makes imported goods more expensive, giving a competitive
advantage to local producers.
2. Generate Government Revenue:
o Especially important in developing countries where other tax
sources may be limited.
3. Correct Trade Deficits:
o Reduces the volume of imports to help balance the country's trade
account.
4. Prevent Dumping:
o Discourages foreign firms from selling goods below cost to
dominate the local market.
5. Retaliation:
o Used in trade wars to counter similar actions taken by another
country.

Effects of Tariffs:
Effect Explanation

Imported goods become expensive; local producers

Increase in Domestic Prices
may also raise prices.

Reduced Import Volumes High tariffs reduce the demand for imported goods.

Government Revenue
More money collected from importers.
Increase

Encouragement of Local Boosts domestic industries by reducing foreign

Production competition.

Possibility of Trade Other countries may impose their own tariffs in

Retaliation response.

Illustrative Example:

Imagine India imposes a 25% tariff on imported shoes from China. If a pair of shoes
costs ₹2,000 in China:

 Tariff = 25% of ₹2,000 = ₹500

  Total cost to importer = ₹2,000 + ₹500 = ₹2,500
 The higher price discourages imports and promotes Indian-made shoes.

Conclusion:

Tariffs are a double-edged sword: they can protect jobs and industries, but they
also raise prices for consumers, reduce choices, and risk international trade
disputes. Economists often recommend using tariffs selectively and temporarily,
especially for supporting infant industries in developing economies.

QUOTA: Definition and Explanation

Definition:

A quota is a quantitative restriction imposed by a government on the amount or

volume of a specific good that can be imported or exported during a given period.
It is a non-tariff barrier used in protectionist trade policy to control the supply of
foreign goods in the domestic market.

Unlike tariffs, which raise the price of imported goods, quotas limit the quantity
directly, which can also lead to higher prices due to reduced supply.

Types of Quotas:
Type Description

Limits the quantity of a specific good that can be

Import Quota
imported.

Export Quota Limits the quantity of a good that can be exported.

Allows a specific quantity at low/no tariff; excess is taxed

Tariff-Rate Quota
at a higher rate.

Voluntary Export A self-imposed export limit by the exporting country,

Restraint (VER) usually under pressure.

Objectives of Quotas:

 To protect domestic industries from excessive foreign competition.

  To conserve foreign exchange by reducing import volumes.
 To reduce dependency on specific foreign goods.
 To maintain domestic employment in vulnerable sectors.

Effects of Quotas:
Effect Explanation

Limited Import Supply Reduces availability of foreign goods.

Less supply leads to higher prices in the domestic

Price Increase
market.

Encouragement of Domestic
Higher prices make local production more profitable.
Output

Quota Rents Importers may earn extra profits (rents) due to scarcity.

Unlike tariffs, quotas do not generate revenue unless

No Government Revenue
combined with licensing fees.

Illustrative Example:

Suppose the government allows only 10,000 TVs to be imported in a year. If

demand exceeds this number, the domestic price rises, benefiting local TV
manufacturers, but hurting consumers who now pay more.

Optimum Tariff: Concept and Explanation

Definition:

An optimum tariff is the tariff rate that maximizes a country's economic welfare,
taking into account its ability to influence international prices. It applies specifically
to large countries that have monopsony power in international trade (i.e., they are
significant enough buyers in global markets to influence prices).

By imposing a tariff on imports, a large country can cause the world price of the
imported good to fall, thereby improving its terms of trade—the ratio of export
prices to import prices.
Mechanism of the Optimum Tariff:

When a large country imposes a tariff:

1. Imports become more expensive domestically.

2. Demand for imports falls in the global market.
3. Exporters in the rest of the world reduce prices to maintain their market.
4. The importing country pays a lower price to foreign sellers (in world prices),
but the domestic price is higher due to the tariff.
5. The difference between the domestic price and the world price is
government revenue.
6. This can result in a net welfare gain, but only up to a certain point.

If the tariff rate is raised too high, the loss in trade volume and economic efficiency
will exceed the gains from improved terms of trade. The point at which these
effects are balanced is the optimum tariff.

Criticism and WTO Perspective:

While theoretically valid, the use of optimum tariffs is controversial in global trade
and is not encouraged under WTO rules. Here's why:

1. Unfair Advantage:

 Large countries could exploit smaller, more dependent trading partners.

2. Risk of Retaliation:

 Other countries may respond with their own tariffs, leading to trade wars.

3. Global Inefficiency:

 Protectionist policies reduce global trade volumes and efficiency.

4. Violation of WTO Principles:

 The WTO promotes free, fair, and rules-based trade.

 Optimum tariffs go against Most-Favored-Nation (MFN) and National
Treatment principles.

5. WTO Restrictions:
  Tariffs are bound and capped under WTO agreements.
 Countries cannot freely impose or increase tariffs without breaching their
commitments.

Conclusion:

 The optimum tariff is a theoretical construct relevant in economic models

for large countries.
 It shows that a country with market power in imports can potentially
improve its welfare by imposing a moderate tariff.
 However, in the real world, such practices are limited by international
agreements, especially the WTO, which seeks to ensure stability,
predictability, and fairness in global trade.
 For small countries, which cannot affect world prices, the optimum tariff is
zero.

UNIT-5

Foreign Direct Investment (FDI)

Definition:

Foreign Direct Investment (FDI) refers to an investment made by a company or

individual from one country into business interests located in another country, in
which the foreign investor has control or significant influence over the operations.

Unlike portfolio investment (which is passive), FDI involves active participation in

management, technology transfer, and long-term interest in the foreign economy.

Types of FDI:

1. Horizontal FDI: Investment in the same industry abroad as the investor

operates at home (e.g., a car manufacturer opening a plant in another
country).
 2. Vertical FDI: Investment in a foreign firm that is part of the supply chain
(e.g., sourcing raw materials).
3. Conglomerate FDI: Investment in an unrelated business abroad.

Modes of FDI Entry:

 Joint ventures
 Wholly owned subsidiaries
 Mergers and acquisitions
 Greenfield investments (starting new operations from scratch)

Importance and Benefits of FDI:

 Brings capital inflow into the host country.

 Promotes technology transfer and innovation.
 Enhances employment opportunities.
 Boosts infrastructure development.
 Improves balance of payments (initially via capital account).
 Leads to global integration of the host economy.
 Encourages competition and efficiency in domestic markets.

Role of Multinational Corporations (MNCs)

Definition:

A Multinational Corporation (MNC) is a company that owns or controls production

or service facilities in more than one country. They are also referred to as
transnational corporations (TNCs).

MNCs are the primary drivers of FDI, as they invest in foreign countries to expand
markets, access cheaper resources, or achieve economies of scale.

Key Roles and Impacts of MNCs:

Role Description

Capital Provider Bring much-needed foreign capital into host countries.

Technology Transfer Introduce advanced technologies, managerial expertise,

 Role Description

and innovation.

Employment Generation Create direct and indirect job opportunities.

Link host countries to global value chains and export

Global Trade Integration
markets.

Invest in logistics, telecom, energy, and transport

Improving Infrastructure
infrastructure.

Train local workers, thus enhancing the labor force's

Skill Development
capabilities.

Boosting Domestic Encourage competition and quality improvement in local

Industry firms.

Concerns and Criticisms of MNCs:

 May repatriate large profits, leading to capital outflows.

 Can dominate local markets, hurting domestic firms.
 Might exploit cheap labor and resources in developing countries.
 Often demand policy concessions and tax breaks.
 Can influence political and economic policies of host nations.

Conclusion:

FDI plays a crucial role in global economic integration and development, especially
for developing countries that lack sufficient domestic capital and technology. MNCs
act as the major agents of FDI, contributing to growth, modernization, and
employment. However, balanced regulation and policy oversight are necessary to
ensure that the benefits of FDI are widely shared and potential risks are minimized.

Foreign Portfolio Investment (FPI)

Definition:
Foreign Portfolio Investment (FPI) refers to the investment by foreign individuals
or institutions in a country’s financial assets, such as stocks, bonds, mutual funds,
and other securities, without gaining direct control or managerial influence over
the enterprises.

FPI is a short-term investment and is part of the capital account in a country’s

Balance of Payments (BoP).

Key Characteristics of FPI:

Feature Description

Nature of
Passive investment in financial markets (shares, bonds).
Investment

Control over
No direct control or management in firms.
Business

Time Horizon Usually short-term or medium-term.

Liquidity Highly liquid; investors can exit easily.

More volatile compared to FDI; sensitive to global and domestic

Volatility
factors.

Motive Capital gains, dividends, interest income.

Instruments Included in FPI:

1. Equity Shares (below 10% ownership)

2. Government Bonds
3. Corporate Debentures and Bonds
4. Mutual Fund Units
5. Exchange-Traded Funds (ETFs)

Importance and Benefits of FPI:

 Increases liquidity in domestic capital markets.

 Diversifies sources of capital for the country.
 Encourages financial market development.
 Enhances foreign exchange reserves.
  Offers capital to firms without diluting control.
 Reflects global investor confidence in the economy.

Risks and Concerns with FPI:

 High volatility: FPIs can exit markets quickly during uncertainty, causing
currency depreciation or stock market crashes.
 No long-term commitment: Unlike FDI, it doesn't result in physical capital
formation or job creation.
 Can cause speculative bubbles in financial markets.
 Sudden withdrawal of FPI leads to "hot money" outflows, destabilizing the
economy.

FPI vs. FDI – Key Differences:

Aspect FPI FDI

Control No control over management Significant control over business

Type of Physical assets (factories,

Fina ncial assets (stocks, bonds)
Investment infrastructure)

Time Horizon Short to medium term Long-term investment

Risk & Return High liquidity, high volatility Relatively stable returns

Impact on Less direct impact on Greater impact on job creation,

Economy employment or tech technology

Regulation of FPI in India:

 Regulated by: Securities and Exchange Board of India (SEBI) and Reserve
Bank of India (RBI).
 Routes: Foreign investors register as Foreign Portfolio Investors (FPIs)
under SEBI regulations.
 Limits: Sectoral limits and ownership caps are in place to prevent excessive
foreign control.
Conclusion:

Foreign Portfolio Investment plays a vital role in strengthening domestic capital

markets and providing access to global funds. However, due to its volatile nature, it
must be carefully managed through sound regulatory frameworks. While it
supports economic development, FPI is no substitute for FDI when it comes to long-
term growth and employment.

International Monetary Fund (IMF)

What is the IMF?

The International Monetary Fund (IMF) is a global organization founded in 1944,

primarily to ensure the stability of the international monetary system—the system
of exchange rates and international payments that enables countries and their
citizens to transact with each other.

Purpose and Objectives:

 Promote international monetary cooperation.

 Facilitate the expansion and balanced growth of international trade.
 Promote exchange rate stability and avoid competitive devaluations.
 Provide resources to member countries facing balance of payments
problems.
 Help countries rebuild reserves, stabilize currencies, and restore economic
growth.
 Provide technical assistance and training to improve economic
management.

Functions:

1. Surveillance: The IMF monitors the global economy and the economies of
member countries to provide policy advice and detect risks early.
2. Financial Assistance: Provides temporary financial support to countries
facing balance of payments difficulties to help stabilize their economies.
 3. Technical Assistance and Training: Helps countries improve their capacity
to design and implement effective policies in areas like fiscal management,
monetary policy, and financial regulation.

Structure:

 Composed of 190+ member countries (as of 2025).

 The voting power of each member is roughly weighted according to its
financial contribution (quota).
 Decisions are made by the Board of Governors and the Executive Board.

Example:

If a country faces a crisis with currency depreciation and can't pay for imports, it can
seek help from the IMF for a loan conditional on implementing reforms.

World Bank

What is the World Bank?

The World Bank is an international financial institution established in 1944, whose

main goal is to reduce poverty by providing financial and technical assistance to
developing countries for development projects.

Purpose and Objectives:

 Provide low-interest loans, zero to low-interest credits, and grants to

developing countries.
 Fund projects that improve infrastructure like roads, schools, hospitals,
water supply, and sanitation.
 Support programs that promote economic development and improve living
standards.
 Help countries build institutional capacity and strengthen governance.

Functions:

1. Project Financing: Provides loans/grants for specific projects such as

building schools, hospitals, or energy plants.
 2. Policy Advice: Offers guidance on economic reforms and development
strategies.
3. Capacity Building: Supports training and development to improve
government management and economic policies.
4. Research: Conducts studies on global development issues.

Structure:

 Consists mainly of two institutions:

o International Bank for Reconstruction and Development (IBRD):
Lends to middle-income and creditworthy low-income countries.
o International Development Association (IDA): Provides
concessional loans and grants to the poorest countries.
 Member countries are shareholders with voting power based on their
financial contributions.

Example:

A country wanting to improve its education system might receive a World Bank loan
to build new schools and train teachers.

Key Differences Between IMF and World Bank

Aspect IMF World Bank

Long-term economic
Monetary cooperation and financial
Main Focus development and poverty
stability
reduction

Provide short- to medium-term

Provide long-term funding for
Primary Role financial assistance to stabilize
development projects
economies

Loans to solve balance of payments Loans and grants for

Assistance Type
issues development projects

Requires economic policy reforms Project implementation and

Conditionality
as loan conditions policy guidance

Member Based on financial quotas Based on financial contributions

Influence influencing voting power and shareholding
 Aspect IMF World Bank

1944, Bretton Woods

Founded 1944, Bretton Woods Conference
Conference