Bec-31 Final

B.A.
, Economics
Third Year
BEC 31
SCHOOL OF SOCIAL SCIENCES

TAMILNADU OPEN UNIVERSITY
Directorate of Technical Education Campus,
Guindy, Chennai – 600 025.
CHAIRMAN
Prof. M.S. Palanichamy,

Vice-Chancellor,
Tamil Nadu Open University,
Chennai - 25.
Editing & Co-ordination
Dr. S.Vijayan,
Professor & Head,
School of Social Sciences,
Chennai - 25.
Dr. M.V.Sudhakaran,
Lecturer,
Chennai - 25.
Dr. N.Dhanalakshmi,
Lecturer,
Chennai - 25.
Course Writer
Mrs.M.Vanitha,
Lecturer (S.G) in Economics,
Department of Economics,
Anna Adarsh College for Women,
Chennai - 40.
First Edition: 2007

© Tamil Nadu Open University
All rights are reserved. No part of this publication may be
reproduced or transmitted in any form without a written permission from Tamil Nadu Open University.
Printers:
B.A., ECONOMICS
INTERNATIONAL ECONOMICS
Syllabus
BLOCK – I INTRODUCTION AND THEORIES OF INTERNATIONAL TRADE
Features and Importance of International Trade – Internal and International trade -

Comparative cost theory – Absolute cost differences – Equal cost differences – Heckscher-
Ohlin Theory – Factor price equalization theory – Role of International trade in Economic
development – Direct and Indirect benefits or Gains – Measurement and distribution of
gains – The contribution of trade to growth and development.
BLOCK – II TERMS OF TRADE AND COMMERCIAL POLICY
Meaning & Importance of Terms of Trade – Types of terms of trade – Factors influencing
Terms of trade - Free trade Vs Protection – Arguments for and against protection – Tariffs
– Types – Quatos – Types.
BLOCK – III BALANCE OF TRADE AND BALANCE OF PAYMENTS
Balance of trade and balance of payments – Balance of payment always balances –

Equilibrium and Disequilibrium in balance of payments – Measures to correct deficit in
balance of payments.
BLOCK – IV FOREIGN EXCHANGE MARKET AND EXCHANGE CONTROL
Functions and Transactions – Meaning of exchange rate – Determination of exchange

rate – Purchasing power parity theory – Fixed exchange rate – Flexible or Floating exchange
rate – Causes for fluctuations in exchange rate – Exchange Control - Meaning – Objectives
– Direct and Indirect methods – Merits & Demerits.
BLOCK – V INTERNATIONAL FINANCIAL INSTITUTIONS AND TRADE

AGREEMENTS
IBRD or World Bank – Functions – Objectives and its working – India & World Bank –
IMF – Functions – Objectives and its working – India & IMF - GATT-WTO – Their impact
on India – Direction and composition of India’s Foreign Trade – Role of MNC’s in India –
Recent Trends in Foreign Trade.
BOOKS RECOMMENDED
1. D.M.Mithani, International Economics, Himalaya Publishing House, Mumbai.
2. M.L. Jhingan, International Economics, Vrinda Publications (P) Ltd., Delhi.
3. Francis Cherunilam, International Economics, Tata Mc-Graw Hill Publishing

Company Ltd., New Delhi.
4. M.C. Vaish and Sudama Singh, International Economics, Oxford and IBH
Publishing Company (P) Ltd., New Delhi.
5. Dwivedi, D.N. International Economics, Tamil Nadu Book House Publishers.

SCHEME OF LESSONS
BLOCK - I INTRODUCTION AND THEORIES OF PAGE NO.

INTERNATIONAL TRADE
Unit 1 International trade Vs. Inter Regional trade 2 - 13
Unit 2 Classical theory (Adamsmith) of International Trade 14 - 21
Unit 3 Neo-classical theory (Haberlers theory of opportunity cost) 22 - 42
Unit 4 Modern theory - International trade 43 - 60
Unit 5 Measurement of distribution of gains from trade 61 - 72
BLOCK - II TERMS OF TRADE AND COMMERCIAL POLICY
Unit 6 Trade policy 74 - 81
Unit 7 Quota and Tariff 82 - 89
Unit 8 Terms of Trade 90 - 98
BLOCK - III BALANCE OF TRADE AND BALANCE OF PAYMENTS
Unit 9 Balance of payment 100 - 111
Unit 10 Foreign trade 112 - 132
BLOCK - IV FOREIGN EXCHANGE MARKET AND

EXCHANGE CONTROL
Unit 11 Foreign exchange 134 - 150

Unit 12 Exchange control 151 - 157
BLOCK - V INTERNATIONAL FINANCIAL INSTITUTION AND

TRADE AGREEMENTS
Unit 13 IMF in India 159 - 177
Unit 14 World bank and India 178 - 191
Unit 15 GATT & WTO 192 - 216

BLOCK - I
INTRODUCTION AND THEORIES OF INTERNATIONAL TRADE
Unit 1 : International trade Vs Inter Regional trade
Unit 2 : Classical Theory of International trade (Adamsmith)

Unit 3 : Neo-classical theory
(Haberlers theory of opportunity cost)
Unit 4 : Modern theory International trade
Unit 5 : Measurement of distribution of gains from trade

2 International trade Vs Inter Regional trade
UNIT 1
INTERNATIONAL TRADE VS
INTER REGIONAL TRADE
STRUCTURE
Overview
Learning Objectives
1.1 Theory of International Trade
1.1.1 Meaning of Inter Regional Trade
1.1.2 Meaning of International Trade
1.1.3 Difference between Inter Regional trade and International trade
1.1.4 Importance of International Trade
1.1.5 Features of International Trade
1.1.6 The contribution of trade to growth and development
1.1.7 Role of international trade in Economic development
Summary
Glossary
Answers to check your progress
Model questions
Books for Reference
OVERVIEW
In this Unit, you are going to learn the meaning of international trade and the
meaning of interregional trade. You are going to learn further difference between
the interregional trade and international trade. Advantages of international trade
is also explained.
LEARNING OBJECTIVES
After studying this unit you will be able to
Ø explain the meaning of International trade

Ø explain the meaning of Interregional trade
Ø explain the differentiate between Interregional trade and international
trade
Ø explain the advantages of International trade.
International Economics 3
1.1 THEORY OF INTERNATIONAL TRADE
1.1.1 MEANING OF INTER REGIONAL TRADE

Interregional trade or domestic trade refers to the exchange of goods and
services between the buyers and sellers within the political boundaries of the
same country.
1.1.2 MEANING OF INTERNATIONAL TRADE

External trade or International trade, on the other hand is the trade between
different countries i.e. it extends beyond the political boundaries of the countries
engaged in it. In other words, it is the trade between two countries. Hence it is
also known as foreign trade.
1.1.3 DIFFERENCE BETWEEN INTER REGIONAL TRADE AND

INTERNATIONAL TRADE
1. Internal and domestic trade refers to the exchange of goods and

services within the geographical boundaries of a nation, while
international trade refers to exchange of goods and services between
two or more countries.
2. Movement of labour between different regions of a country will be easy
and common. But this will not be so in the case of international trade. The
reasons are obvious. Barriers connected with language, national habits
and sentiments, and in recent times, stringent legal restrictions obstruct
the free flow of labour between different countries. The result of this is
very important. Because of free movement of labour internally, there is a
tendency towards equality of wages for given intensity and skill. But great
differences in the rates of wages may prevail in different countries. “The
general level of real wages is roughly twice as high in New York as in
London, roughly twice as high in London as in Rome. Such differences
could not continue for long in one country. What is true of the movement
of labour applies, though to a less degree, to the movement of capital and
enterprise. The essential difference between international and international
trade is the immobility of factors of production.
3. Each country has a different currency. As India has the ‘rupees’, USA
has its ‘dollar’, Germany the ‘mark’, Japan the ‘yen’ and Spain the ‘peso’.
Hence, international trade gives rise to many currency complications.
Finding out the exchange rate and settling debits and credits are the
major problems in international transactions. The complications will
be more if the exchange rate is fluctuating. In the internal trade, there
is no such complication as the monetary unit is the same.
4. The citizens of one country are subject to the same system of national
and local taxation, to the same regulation and laws, regarding industry
and labour. Even if capital and labour moved freely between countries
so that wages, interest charges, profits etc., were the same
everywhere, the general level of real costs might be lower in one country
than another because of certain superior advantages provided by the
system of government.
5. People posses a very good knowledge of the conditions of trade in
their own country. But cannot be so conversant with the conditions
obtained in other countries. The lack of knowledge may hinder
international trade.
6. Trade between countries is not free as in the case of different regions
of the same country. It often trade restrictions are imposed by customs
duties, exchange restrictions, quotas and tariff barriers.
7. Each country is under the control of separate banking system governed
by the Central Bank of the country having a separate monetary policy
which will vitally after the foreign trade. Thus, there are many differences
between internal and international trade and many hindrances for the latter.
1.1.4 IMPORTANCE OF INTERNATIONAL TRADE
1. Attaining High profit : The basic objective of every business concern is to
earn high profit. If the domestic markets do not assure a higher profit, they go
for foreign market, which assures a higher rate of profit.
2. Expansion of Production over and above the Domestic Requirements :

If any business concern expands its production capacity over and above its
local requirements, it has to go to foreign markets to sell its excess production.
Toyota of Japan can be cited as an example here.
3. Meeting tough competition in the home country : Concerns that face

severe competition in home country may enter foreign markets for selling
their goods. If concerns are of small in size, they may find it difficult to compete
with the concern of stronger ones. In such case, generally weak companies
search for foreign markets and enter them.
4. Inadequate scope in Home Market : If the scope in home market is

inadequate, firms may go to foreign markets. Such an inadequate scope for
goods may be due to lower purchasing power or smaller size of the population.
5. Political Instability : Political instability is another reason, which makes

firms to move from one country to another. Political stability is a must for firms
to withstand and flourish in any country. So generally firms prefer to enter
politically stable countries like U.S.A., U.K., Japan, France, Germany and Italy.
On the other hand, India, Malaysia, Indonesia, Singapore etc. are categorized
as politically instable countries.
6. Ample Scope for advanced technology and Managerial Competence :

Very often, firms move form their own countries to other countries where the
advanced technology and managerial competence are available.
7. Liberalization and Globalization : Mostly, countries, all over the world

liberalized their economies in order to open up their countries to the rest of the
world. This is another reason for the development of international trade.
1.1.5 FEATURES OF INTERNATIONAL TRADE

The various features of international trade are discussed below :
1. Immobility of Resources : Various factors of production such as labour,

capital etc. are not easily movable from one country to another. Further the
degree of mobility of these factors also varies greatly between different in
international trade. This is the peculiar feature of international trade.
2. Heterogeneous Markets : International trade involves heterogeneous
markets because there is difference in languages, preferences, customs,
currency, weights, measures etc. Hence, the buyer behaviour also would be
different in international trade. This is the peculiar feature of international trade.
3. Trade among difference nations : It is a trade between different nations.
Under this trade, the socio-economic environment varies greatly among
different nations.
4. Difference type of currencies : International trade involves the exchange
of different type of currencies. It creates problem in exchange rates, greatly
among policies etc.
5. Different political groups : Another important feature of international trade

is that different countries have different units. However, in internal trade all
regions within a country belong to one particular unit. Further, internal trade is
carried on between people belonging to the same country. They may differ on
the basis of castes, creeds, religions, tastes or customs. However, they have
a sense of belonging to one national and their loyalty to the region is secondary.
The Government is also interested more in the welfare of its nationals belonging
to different regions. But in international trade there is no cohesion among
nations. Here every country trades with other countries in its own interests.
Often they trade to the detriment of others. IN this context, Friendrich List
remarked as follows : “Domestic trade is among us, international trade is
between us and them”.
6. Geographical and climatic differences : Each country cannot produce

all the commodities on account of geographical and climatic conditions. For
instance, India has favourable climatic and geographical conditions for the
production of coffee, Bangladesh for jute, Brazil for coffee, Cuba for beet sugar
etc. So countries having climatic and geographical advantages specialise in
the production of particular commodities and trade them with others.
7. Problem of Balance of Payments : The problem of balance of payments

is another important point, which distinguishes internal trade from international
trade. The problem of balance of payments is continuous in international
trade. On the other hand, regions within a country have no such problem. This
is because there is greater mobility of capital within regions than between
countries. Further, the policies, which a country chooses to correct its
disequilibrium in the balance of payments, may give rise to a number of other
problems. If it adopts deflation or devaluation or restrictions on imports or the
movement of currency, they create further problems. But such problems do
not arise in the case of international trade.
8. High Transport : Trade between countries involves high transport cost as

against trade within a country. This is because geographical distance between
different countries are too great.
9. Different Economic Environment : Countries differ in their economic

environment, which affects their trade relations. The legal framework, institutional
set-up monetary, fiscal and commercial policies, factor endowments, production
techniques, nature of products etc. differ between countries. But there is not
much difference in the economic environment within a country.
1.1.6 THE CONTRIBUTION OF TRADE TO GROWTH AND DEVELOPMENT

D.H. Robertson has made the profound observation that trade is ‘an engine of
growth’. Though he has made this observation in the context of the nineteenth
century developments, a number of economists maintain that it is equally true
of today. For instance, Haberler has argued that international trade has made
a tremendous contribution to the development of less developed countries in
the 19th and 20th centuries and can be expected to make an equally big
contribution in the future, if it is allowed to proceed freely. He has, however,
made it clear that it does not necessarily follow that a 100 per cent free trade
policy is always most conducive to most rapid development and that marginal
interference with the free flow of trade may speed up development. Haberler
further notes that drastic deviations from free trade can be justified, on
development grounds. According to Cairncross, “as often as not, it is trade
that gives birth to the urge to develop, the knowledge and experience that
make development possible, and the means to accomplish it”.
Haberler lists the following benefits of trade to stress the importance of trade
to development of the less developed countries.
First, trade provides material means 9capital goods, machinery and raw and
semi finished material) indispensable for economic development.
Secondly, even more important trade is the means and vehicle for the
dissemination of technological knowledge, the transmission of ideas, for the
importation of know-how, skills, managerial talents and entrepreneurship.
Thirdly, trade is also the vehicle for the international movement of capital
especially from the developed to the underdeveloped countries.
Fourthly, free international trade is the best anti-monopoly policy and the best
guarantee for the maintenance of a healthy degree of free competition.
1.1.7 ADVANTAGES OF INTERNATIONAL TRADE

i. Divisional of labour and specialisation
International trade is very beneficial to countries in several respects. The most

important advantage is the Division of labour and consequent specialisation.
Countries differ with regard to geographical position, climatic conditions, mineral

wealth etc., and consequently each country is more fitted than others to produce
certain goods. For instance, Britain has iron ores in plenty and good quality of
coal. Middle East countries have plenty of oil resources. India and Sri Lanka
have tea, and south East countries have in the rubber. Countries which have a
special advantage in anything, specialise in the production of that article and
exchange it for another article for which another country is eminently suited.
The classical examples of Adamsmith and Ricardo illustrate the advantages of
division of labour and specialisation. Adam smith wrote : “It is the maxim of
every prudent master of a family never to attempt to make at home what it will
cost him more to make than to buy. The tailor does not attempt to make his own
shoes, but buys them from the shoe-maker. The shoe-maker does not attempt
to make his own clothes, but employs a tailor. The farmer attempts to make
neither the one or the other but employees these different artificers. All of them
find it for their interest to employ their whole industry in a way in which they have
some advantage over their neighbours, and to purchase with a part of its produce,
or what is the samething, with the price of a part of it, whatever else they have
occasion for. What is prudent in the conduct of every private family can scarcely
be folly in that of a great kingdom. If a foreign country can supply us with a
commodity cheaper than we ourselves can make it, better buy it from them with
some part of the produce of our own industry employed in a way in which we
have some advantage. Nothing can be more forceful than Adam Smith’s
celebrated statement, defending the principle of division of labour and international
exchange of goods and services.
After Adam Smith, David Ricardo also brought home the same point with equally
forceful illustration; “Two men can both make shoes and hats and one is
superior to the other in both employments, but, in making hats he excels his
competitor by one-fifth or 20 per cent and in making shoes he excels him by
one third or 33 1/3 per cent. Will it not be in the interest of both that the
superior man should employ himself exclusively in making hats. Thus, the
illustrations of Ricardo and Smith bring out elegantly the advantages of division
of labour and specialisation.
ii. Reduction of prices
By pushing forward specialisation and extending the scope of division of labour,

international trade lowers the prices of goods and services all over the world.
Consequently, it stimulates their consumption and demand which cause further

specialisation and technological progress a reality.
iii. Reduces Monopolistic Exploitation
In international trade, particularly under free trade, there is maximum scope of

optimum utilisation and a allocation of world’s scarce resources. A country
can sell her products in those markets where she can get the best prices for
her products and buy essential raw materials and other consumer goods from
the cheapest sources of supply. As a result, a country enjoys the maximum
advantages, both as a consumer and as a producer. Exploitation of one country
by another is difficult since there are numerous buyers of her goods and she
can also buy her requirements from various competing sources of supply.
Thus, international trade reduces monopolistic and monopsonistic exploitation.
iv. National Well-Being

For many nations, international trade is literally master of life and death. For
example, it is physically impossible for the United Kingdom and Japan to feed
clothe and house their present populations without imports from other countries.
The survival of these countries depends on the exports of their manufactured
goods. Although U.K. and Japan are given as examples here, there are several
other nations which are extremely dependent on international trade. In the
case of many countries, the living standards would fall considerably if they
were cut off from international trade. Australia and New Zealand produce lot of
foodstuffs than is required to feed their sparse population, and they trade off
this surplus for manufactured goods with industrial countries like the U.K. and
Japan. Thus, for Australia and New Zealand, self-sufficiency does not mean
adequate food, but other manufactured goods for sustaining their living
standards. Even very rich countries like USA, could not afford to be self-
sufficient as the cost of self-sufficiency will be very high and the average
American would be reluctant to bear this cost. A large range of foodstuffs
which figure in the diet of every American of average means would no longer
be available, or would be available only exorbitant prices, in the absence of
international trade. In the case of America, the morning cup of coffee would
become a luxury without international trade. For many countries, sugar would
become a scarce and expensive commodity without international trade. It
should be understood that much of the fall in the standards of living of people
during the war is due to the cessation of international trade.
v. Protection of Economic Interests
International trade protects economic interests of all countries. During the First
World War and interwar period, many countries were denied free access to
world markets. Consequently, the problem of procuring essential raw materials
became so actue that it became almost impossible for certain countries like
Japan, Germany and Italy to import raw materials from the raw materials
producing countries, which were mostly the colonies of England and France. In
the League on Nations and other international forums, these countries agitated
for redistribution of the colonies. Japan attacked China and took away Manchuria
which was the rich producer of coal, iron, ore, soyabean, etc.
vi. Facilitates Debt payment
International trade depends on the multilateral payments system which makes it

possible to effect payments from debtor to creditor countries by enabling the former
to create the necessary amount of export surplus in their balance of trade.
vii. Working of International Monetary system
International trade facilities the working of an international monetary system

with free multilateral convertibility of currencies. Free trade is a pre-requisite
of international economic operations, brotherhood and listing world peace.
viii. Poor and Backward nationals can become rich and forward
It is only due to international trade, many countries which were very poor and
backward have become very rich and forward. The unprecedented prosperity
enjoyed by the OPEC nations (Organisation of the Petroleum Exporting
Countries) would have been impossible, but for the ready world demand for
their petrol and petroleum with industrial activities owning a substantial chunk of
equity and financial investment in international money and capital markets.
Without international trade, their was petrol reserves would have remained
unexploited, and most of these countries of the middle-each would have remained
world’s poorest desert countries. Date to international trade, their economic lot
has been transformed and they have become world’s richest nations.
ix. Changes in the quality of Labour and Capital
International trade brings about fundamental changes in the quality of labour

and capital in trading countries. This have been explained by Bertil Ohlin thus
: “International trade changes the fundamental facts of economic life in trading

nations, and cannot fail to affect in a thousand and one ways the factors
governing the output of labour and capital. The few reaching nature of the
indirect influence is best realised, if we ask what the world’s population and
capital equipment would be like, if there had been no international trade, and
few different it would be from the present situation. We can only say that the
difference would be enormous and that it cannot be adequately dealt with in
quantitative terms. Trade changes the quality of the people, teaches them to
consume new things and to use old things in new ways. Technical knowledge
is largely the result of specialisation, which trade has made possible. The
character, not only of so-called technical labour, but also of skilled and unskilled
labour is affected”.
x. Equal access to Raw Materials and Markets
Free trade will be non-discriminatory in character and as such, this will enable
the countries to have equal access to the raw materials and world market to
all countries of the world. During the thirties of 20th century, some developed
countries including Germany, Italy and Japan themselves demanded free and
equal access to the world’s raw materials. It was so because, in the thirties
the multilateral trading system was throttled by various quantitative and foreign
exchange controls. Under free trade, every country has equal access to raw
materials and other goods. Consequently, the sources of supply of essential
raw materials cease to be the monopoly of the favoured few.
xi. Expansion in Volume of Trade
Another notworthy advantage of international trade is its 0phenomenal
expansion in the volume of world trade. The volume of international trade and
not remained static, it was every-increasing. Between 1963 and 1986, world
exports in value terms expanded from 155 billion dollars to 2450 billion dollars,
a fantastic sixteen-fold expansion of world trade in a period little over two
decades. In 1991 in increased to 3500 billion US dollars. In the terms of
volumes, the index more than trebled during the period. Even allowing for the
increase in the unit value, world trade expanded from 155 billion dollars in
1963 to over 900 billion dollars in 1991 at constant prices.
The advantages of international trade are many and these advantages have
several ramifications. The so called criticism that international trade will
adversely affect wages, particularly when trade takes place between two
countries where wages are low in one and high in another. The low wages of
one country will not depress the high wages in the other with which international
trade takes place. This fallacy has been exposed by Taussig who says that
this is unfounded. There is no such tendency in equalisation of wages. The
question of wages depends on productivity, greater the productivity of industry,
the higher will be the general level of wages.
CHECK YOUR PROGRESS
A. State whether the following statements are True or False.
1. Inter-regional trade refers to trade between regions within a country.

2. International is trade between two nations or countries.
3. The principal difference between inter-regional and international trade
lies in use of different currencies in Foreign trade.
SUMMARY
The difference between the inter regional trade and international trade are
factor immobility. Differences in Natural Resources, Geographical and climatic
differences, different markets. Mobility of goods, different currencies, problem
of Balance of Payments, Different transport costs different economic
environment, different political groups, different national policies. The
advantages of International trade are division of labour and specialisation,
reduction of prices, reduction of monopolistic competition, national well being.
Protection of Economic Interests, International trade facilitates the working of
an international monetary system with free multilateral convertibility of
currencies.
GLOSSARY
Inter - regional Trade : Refers to trade between regions within a country.
International trade : It is trade between two nations or countries.
Gains from Trade : Net benefits or increases in goods that a country

obtain by trading with other countries.
ANSWERS TO CHECK YOUR PROGRESS
1.True 2.True 3.True

MODEL QUESTIONS
1. What is inter-regional trade?

2. Explain International trade.
3. Bring out the difference between Inter-regional trade and International trade.
4. Describe the advantages of International trade.
BOOKS FOR REFERENCE
1. M.L.Jhingan, International Economics.

2. D.M.Mithani, International Economics.
3. M.C.Vaish, International Economics.
4. Francis Cherunilam, International Economics.
5. Soderston B. International Economics.
14 Classical theory Adamsmith of International trade
UNIT 2
CLASSICAL THEORY
ADAMSMITH OF INTERNATIONAL
TRADE
STRUCTURE
Overview
Learning Objectives
2.1 Adamsmith theory of International trade
2.1.1 Smith’s theory of absolute differences in costs
2.1.2 Explanation of the theory
2.1.3 Diagrammatic representation of the theory
2.1.4 Comparative Cost Theory of Ricardo
2.1.5 Assumptions of the theory
2.1.7 Diagrammatic representation of the theory
2.1.8 Equal cost different
Summary
Glossary
Model questions
Books for reference
OVERVIEW
In this Unit, you are going to learn the meaning of absolute cost differences
and the explanation of the theory. You are going to learn further the
diagrammatic representation of the theory. Hence, you are going to learn
comparative cost theory and assumption of the theory. Your are going to learn
further the explanation of the theory of comparative cost. Ricardos theory is
also explained with the diagram.
LEARNING OBJECTIVES
After studying this unit, you will be able to
Ø explain the meaning of absolute cost advantage

Ø explain the diagrammatic representation of the theory
Ø describe the Adamsmiths absolute cost difference
Ø explain the meaning of the comparative cost differences
Ø explain the assumptions of Ricardo’s theory
Ø describe the theory
Ø explain the diagrammatic representation of the theory
2.1 ADAMSMITH THEORY OF INTERNATIONAL TRADE
The classical theory of international trade was first formulated by Robert

Torrens, David Ricardo and John Stuart Mill. Their ideas relate to the theory of
comparative cost or advantage. Adam Smith, the first classical economist,
advocated the principle of absolute advantage as the basis of international
trade which was discarded by Ricardo. But the Ricardian theory of comparative
advantage has been accepted and improved upon by modern economists
like Taussig and Haberler.
2.1.1 SMITH’S THEORY OF ABSOLUTE DIFFERENCES IN COSTS

AdamSmith extolled the virtues of free trade. These are the result of the
advantages of division of labour and specilisation both at the national and
International levels. The division of labour at the international level requires the
existence of absolute difference in costs. Every country should specialise in
the production of that commodity which it can produce more cheaply than
others and exchange it for the commodities which cost less in other countries.
According to Smith, “Whether the advantage which one country has over
another be natural or acquired, is in this respect of no consequence”.
2.1.2 EXPLANATION OF THE THEORY

To illustrate, let there be two countries, A and B, having absolute differences in
costs in producing a commodity each, X and Y respectively, at an absolute
lower cost of production than the other. The absolute cost differences are
illustrated in Table - 1.
Table -1 : Absolute Differences in Costs
Country Commodity - X Commodity – Y
A 10 5
B 5 10
The table reveals that country A can produce 10X or 5Y with one unit of labour
and country B can produce 5X or 10Y with one unit of labour. In this case,
country A has an absolute advantage in the production of X (for 10X is greater
than 5X), and country B has an absolute advantage in the production of Y (for
10Y is greater than 5Y). This can be expressed as
10X of A 5Y of A
>1>
5X of B 10Y of B
2.1.3 DIAGRAMMATIC REPRESENTATION OF THE THEORY
Fig.No. 1 Absolute differences in costs
The above diagrame illustrates absolute differences in costs with the help of
production possibility curves. XA YA is the production possibility curve of country
A which shows that it can produce either OXA of commodity X or OYA of
commodity Y. Similarly, country B can produce OXB of commodity X or OYB
of commodity Y. The figure also reveals that A has an absolute advantage in
the production of commodity X (OXA > OXB) and country B has an absolute
advantage in the production of commodity Y (OYB > OYA).
2.1.4 COMPARATIVE COST THEORY OF RICARDO

The classical theory of international trade was first formulated by Robert
Torrens, David Ricardo and John Stuart Mill. Their ideas relate to the theory of
comparative cost or advantage. Adam Smith, the first classical economist,
advocated the principle of absolute advantage as the basis of international

trade which was discarded by Ricardo. But the Ricardian theory of comparative
advantage has been accepted and improved upon by modern economists
like Taussig and Haberler.
2.1.5 ASSUMPTIONS OF THE THEORY

The Ricardian theory of comparative advantage is based on the following
assumptions :
1. There are only two countries, say England and Portugal.

2. They produce the same two commodities say, wine and cloth.
3. There are similar tastes in both countries.
4. Labour is the only factor of production.
5. The supply of labour is unchanged.
6. All units of labour are homogeneous
7. Prices of two commodities are determined by labour cost, i.e., the
number of labour- units employed to produce each.
8. Commodities are produced under the law of constant costs or returns.
9. Technological knowledge is unchanged.
10. Trade between the two countries takes place on the basis of the barter
system.
11. Factors or production are perfectly mobile within each country, but are
perfectly immobile countries.
12. There is free trade between the two countries, there being no trade
barriers or restrictions in the movement of commodities.
13. No transport costs are involved in carrying trade between the two
countries.
14. All factors of production are fully employed in both the countries.
15. The international market is perfect so that the exchange ratio for the
two commodities is the same.
Given these assumptions, Ricardo shows that trade is possible between two
countries when one country has an absolute advantage in the production of
both commodities, but a comparative advantage in the production of one
commodity than in the other. This is illustrated in terms of Ricardo’s well-

known example of trade between England and Portugal as shown in Table - 2.
Table -2 : Man-years of labour required for producing one unit
Country Wine Cloth
England 120 100

Portugal 80 90
The table shows that the production of a unit of wine in England requires 120
men for a year, while a unit of cloth requires 100 men for the same period. On
the other hand, the production of the same quantities of wine and cloth in
Portugal requires 80 and 90 men respectively. Thus, England uses more labour
than Portugal in producing both wine and cloth. In other words, the Portuguese
labour is more efficient than the English labour in producing both the products.
So Portugal possesses an absolute advantage in both wine and cloth. But
Portugal would benefit more by producing wine and exporting it to England
because it possesses greater comparative advantage in it. This is because
the cost of production of wine (80/120 men) is less than the cost of production
of cloth (90/100 men). On the other hand, it is in England’s interest to specialise
in the production of cloth in which it has the least comparative disadvantage.
This is because the cost of production of cloth in England in less (100/90
men) as compared with wine (120/80 men). Thus, trade is beneficial for both
the countries. The comparative advantage position of both is illustrated in Fig.2
in terms of production possibility curves.
E
Cloth
O
G R L
Wine
Fig.No.2 Production possibility curves
2.1.7 DIAGRAMMATIC REPRESENTATION OF THE THEORY

PL is the production possibility curve of Portugal, and EG that of England.
Portugal enjoys an absolute advantage in the production of both wine and
cloth over England. It produces OL of wine and OP of cloth, as against OG of
wine and OE of cloth produced by England. But the slope of ER (parallel to
PL) reveals the Portugal has a greater comparative advantage in the production
of wine because it if given up the resources required to produce OE of cloth,
it can produce OR of wine which is greater than OG of wine of England. On
the other hand, England had the least comparative disadvantage in the
production of OE of cloth. Thus, Portugal will export OR of wine of England in
exchange for OE of cloth from her.
2.1.8 EQUAL COST DIFFERENCES

International trade can be profitable only when there are comparative differences
in the two countries. On the contrary, if there are equal differences in production
costs, international trade cannot take place. The reason is that there is hardly
any possibility of profit in international trade if there are equal differences in
production costs between the two countries. Hence, international trade
automatically comes to an end. This can be illustrated with the following example:
India can produce with 1 unit of labour either 2 units of jute or 2 units of cotton.
Egypt can produce with I unit of labour either 1 unit of Jute or 1 unit of cotton.
In the above example, there are equal differences in the production costs of
the two countries. India can produce both jute and cotton at a lesser cost
than, Egypt. If there were no international trade, then the exchange ratio between
jute and cotton in India would have been 1 : 1. This exchange ratio would also
be applicable to Egypt. Now if India produces jute only and imports cotton
from Egypt it earns no profit, because the exchange ratio between cotton and
jute in Egypt is the same as in India. In other words, India cannot get from
Egypt more than one unit of cotton against one unit of jute. But one unit of
cotton is already available in exchange for one unit of jute, in India. Thus,
under these circumstances. India’s trade with Egypt will actually prove harmful
because if India imports cotton from Egypt, it will have to bear transport and
insurance charges as well. Thus, there is no gain from international trade if
there are equal differences in production costs between the two countries. .
CHECK YOUR PROGRESS
1. Adamsmith advocated the principle of absolute advantage as the basis

of International trade.
2. Division of labour and specialization are the causes of absolute cost
differences.
3. If there is equal cost difference, trade cannot take place
4. The theory of comparative advantage was propounded by David
Ricardo.
5. In Ricardo’s view, differences in labour costs of production are the
cause of comparative cost differences.
6. In Ricardo’s theory we assume both the countries are having similar
tastes.
7. The theory of comparative advantage was propounded by David
Ricardo.
8. In Ricardo’s view, differences in labour costs of production are the
cause of comparative cost differences.
9. In Ricardo’s theory we assume both the countries are having similar
tastes.
SUMMARY
The classical theory of international trade was formulated by the classical

economists like Adam Smith, David, Ricardo and J.S.Mill. It is based on the
simple fact that different countries are endowed with the capacity of producing
different commodities by virtual of their geographical and physical differences.
Every country produces those goods in the production of which it has certain
special advantages. Accordingly every country exports those goods in the
production of which it has cost advantages and imports those goods in the
production of which it has cost disadvantages.
According to David Ricardo, it is not the absolute but the comparative difference
in costs that determine trade relations between two countries. In Ricardo’s
theory, each country will specialise in the production of those commodities in
which, has the greatest advantage or the least comparative disadvantage.
GLOSSARY
Production possibility curve : It shows the various alternative combination

of the two commodities that a country can produce most efficiently be fully
utilizing its factors of production with the available technology.
International Trade : The mutually profitable exchange of goods between

the people of different countries residing in different geographical location.
1.True, 2.True 3.True 4.True 5.True

6.True 7.True 8.True 9.True
MODEL QUESTIONS
1. Describe the absolute cost difference theory?

2. Explain the diagrammatic representation of Adamsmith’s Theory?
3. What is comparative cost difference?
4. Bring out various assumptions of Ricardo theory?
5. Describe the diagrammatic representation of theory of comparative cost?
6. What is comparative cost difference?
7. Bring out various assumptions of Ricardo theory?
8. Describe the diagrammatic representation of theory of comparative cost?
BOOKS FOR REFERENCE
1. M.L.Jhingan, International Economics, Vrinda Publications (P) Ltd.

2. D.M.Mithani, International Economics, Himalaya Publishing House.
3. M.C. Vaish, International Economics.
4. Francis Cherunilam, International Economics. Taha McGraw Hill
Publishing Company Limited.
5. Sodersten. B, International Economics.
22 Neo classical theory
UNIT 3
NEO CLASSICAL THEORY
HABERLERS THEORY OF
OPPORTUNITY COST
STRUCTURE
Overview
Learning Objectives
3.1 Haberlers theory
3.1.1 What is mean by opportunity cost
3.1.2 Haberler’s approach through opportunity cost
3.1.3 Assumptions of the theory
3.1.5 Trade under constant opportunity cost
3.1.6 Trade under increasing opportunity cost
3.1.7 Trade under decreasing opportunity cost (or) increasing returns
Summary
Glossary
Model Questions
Books for Reference
OVERVIEW
In this Unit, you are going to learn the meaning of Haberlers opportunity cost
theory and the assumptions of the theory. You will further learn the diagrammatic
representation of the theory.
LEARNING OBJECTIVES
Ø explain the meaning of Haberlers opportunity cost theory

Ø explain the assumptions of the theory
Ø describe the diagrammatic representation of the theory.
3.1 HABERLERS THEORY
3.1.1 WHAT IS MEAN BY OPPORTUNITY COST?

The economic principle behind cost in the modern sense is not the pain or
strain involved, nor the money cost involved in producing a thing. It depends
on the sacrifice of alternative product that could have been produced. This
means that the “cost of using something in particular venture is the benefit
foregone by not using it in its best alternative use”.
The opportunity cost of any commodity is the next best alternative commodity
that is sacrificed. They take the form of profits from alternative ventures that
are sacrificed.
Opportunity costs require the measurement of sacrifices. When alternatives

are clear and relate to short-run, the opportunity cost of sacrificing them can
be easily calculated.
“In a cloth mill that spins its own yarn, for example, the cost of yarn is really the
price at which the yarn could be sold if it were not woven into cloth. For the
problem of measuring the profitability of the weaving operations in order to
decide whether to expand them or abandon them, it is this opportunity cost -
the foregone revenue from not selling the yearn - that is relevant”.
The concept of opportunity cost can also be used in the long-term decisions.
For example, in the case of college education, the cost includes not only the
books, tution fees etc., but also the income which is foregone in not being
employed on a full time basis. In military affairs, the cost of sending bombers
on a particular mission is not the price of fuel to operate the planes and the
price of ammunitions, but the damage they would have done to enemy had
they been sent on a substitute mission.
3.1.2 HABERLER’S APPROACH THROUGH OPPORTUNITY COST

The basic contention of Haberler is that the relative prices of commodities are
determined by their cost conditions. The costs do not, however, refer to the
amount of labour contained in the production of the commodity, but to the
production of some other commodity which has to be foregone for producing
the commodity in question. From this, it follows that the cost of production of
any particular commodity is the value of the commodity whose production is
given up in order to produce that commodity.
According to Haberler, “the marginal cost of given quantity x of commodity A

must be regarded as that quantity of commodity B which must be foregone in
order that x, instead of x - 1 units of A can be produced. The exchange - ratio
on the market between A and B must equal their cost in this sense of the term.
Thus Substitution Curve of Haberler is also called “Production Possibility Curve”
or “Transformation Curve” by Samuelson. Lerner calls it “Production
Indifference Curve” or “Production Frontier”.
In offering his opportunity cost doctrine, Haberler emphasised the role of

differing factor endowments of the trading countries; but assumed for simplicity
that the factors available to a country are fixed in supply. These factors can be
used in several ways; some of the output of one commodity can be sacrificed
to increase the output of another so that each country can exhibit a set of
production possibilities.
3.1.3 ASSUMPTIONS OF THE THEORY

In analysing the theory of “opportunity cost”, Haberler has made the following
assumptions :
1. There are only two countries and each country possesses two factors
of production, viz., labour and capital.
2. Each country can produce only two commodities.
3. There is perfect competition in the factor market and also in the
commodity market.
4. The price of each commodity equals its marginal money costs.
5. The price of each factors equals its marginal value productivity in each
employment.
6. The supply of each factor is fixed.
7. There is full employment in each country
8. The technology remains constant.
9. Factors are immobile between the two countries and completely mobile
within countries.
10. Trade between the two countries is completely free and unrestricted.
With the above stated assumptions, production possibility curves of the two
countries can be drawn with the help of data of alternative combinations of the
two commodities that can be produced, fully utilising the factors of production
with available technology. The slope of the production possibility curve
measures the amount of one commodity that a country must give up in order
to get an additional unit of the second commodity. In other words, the slope of
the production possibility curve is its marginal rate of transformation.
It is the shape of the production possibility curve under different cost conditions
that determines the basis and the gains from international trade under the
theory of opportunity costs. If the amount of Y required to be given up to get
additional quantity of X remain constant, the production possibility curve would
be a straight line and it would indicate constant opportunity costs. If more
quantity of Y is required to be given up in order to have an additional quantity of
X, of production possibility curve would be concave to the origin and it would
indicate increasing opportunity costs. Lastly, if in order to get an additional
quantity of X, less quantity of Y is required to be given up, the production
possibility curve would be convex to the origin, and it would indicate diminishing
opportunity costs.
The following figures, viz., figure 3.1, figure 3.2, figure 3.3 and figure 3.4 indicate
the shape of the production possibilities curve under different conditions.
Under constant returns to scale or constant opportunity cost, the production

possibilities curve will be linear as shown in the figure 3.1.
Fig.No. 3.1 : Constant Returns (or) Constant Opportunity Cost

Fig.No. 3.2 : Diminishing Returns (or) Increasing Opportunity Cost
Under diminishing returns to scale or increasing opportunity cost, production

possibility curve will be concave viewed from the origin of the axes, as shown
in figure 3.2. Under increasing returns to scale or decreasing opportunity cost
of production, the production possibility curve will convex towards the point of
origin of the axes, as shown in figure 3.3. Besides these three possibilities,
there may be several possible outcomes in the shape of the production
possibility curves. A combination of these has been illustrated in the figure 3.4.
Fig.No.3.3 : Increasing Returns (or) Decreasing Opportunity Cost

Fig.No. 3.4 : Combinations of Increasing & Decreasing Returns

(or) Opportunity Costs
From the figures, it is evident that under constant returns, the marginal rate of
substitution between cloth and wheat is constant along the production possibility
curve AB in figure 3.1. In the case of diminishing returns, the marginal rate of
commodity substitution between cloth and wheat is increasing showing that
the opportunity cost of producing wheat in terms of quantity of cloth foregone
is increasing along the production possibilities curve AB, as shown in figure
3.2. Under increasing returns or the decreasing opportunity cost, the marginal
rate of commodity substitution is diminishing as shown in figure 3.3. In other
words, as the output of wheat increases its unit cost of production in terms of
the quantity of cloth sacrificed decreases. The figures 3.4 is a combination of
figure 3.2, and 3.3 showing that over the AE range of production possibilities,
the rate of commodity substitution is diminishing while beyond E, this rate is
increasing. E is the point of inflexion where momentarily the rate of change of
the slope of the production possibilities curve is zero. A typical production
possibilities curve will usually be of this shape, displaying the operation of the
law of varying proportions is production.
With these preliminary explanations regarding production possibilities curve

and the rate of substitution between the two commodities, we have to discuss
trading between two countries under (i) Constant opportunity cost; (ii)
Increasing opportunity cost; and (iii) Diminishing opportunity cost.
3.1.5 TRADE UNDER CONSTANT OPPORTUNITY COST

We know that under constant opportunity costs, the production possibilities
curve will be a straight line showing that the rate of commodity substitution
defined as the units of one commodity foregone to obtain an extra unit of the
other commodity is always constant. Since the rate of commodity substitution
is constant, the relative costs of production of commodities will remain constant
irrespective of the ratio in which they are demanded and produced.
When the production of both the commodities in the two countries is taking place
under constant returns, the possibility of gain from trade emerges only when the
slopes of the production possibilities curves of the two countries are different. If
the slopes of the PP curves of the two countries were to be the same, there will
be no trade, as the relative prices of commodities in both the countries will be
equal. In other words, in the case of iso-sloped (parallel production possibilities)
curves between two countries, there will be no trade at all.
This is illustrated in the figure 3.5 in which the production possibilities curve of
country A is straight line AB and the production possibilities curve of country
‘B’ is A1B1. But they are iso-sloped i.e., the PP curves of the two countries A
and B are parallel to each other. The slope of AB is OA/OB. The slope of A1B1
is OA1/OB1. This is equal of OA/OB. Consequently, the exchange ratio in the
two countries are identical. Since the slopes of both the production possibilities
curves are equal, differences in relative prices in the two countries do not
exist. In other words, the relative cost of producing wheat in terms of the quantity
of cloth foregone is equal in both the countries and there is no scope for gain
from trade. Hence, trade will not take place between the two countries.
Fig.No. 3.5 : Increasing Returns (or) Decreasing Opportunity Cost
From this, it is evident that the slopes of the PP curves of the two countries
should be different in order to have benefit in trade between them. Different
slopes of PP can be had only in cases where the comparative costs are
different in the two countries.
Nextly, we shall discuss about the phenomenon of trade taking place between
the two countries A and B which are of equal economic size with differences
in comparative costs.
Figure 3.6, illustrates the production possibility curves of Country A and Country B
producing wheat and cloth. They are of equal economic size. With specified factor
endowments, Country A can produce either OA output of cloth and no wheat or
OB output of wheat and no cloth, or any one of the many possible combinations of
the two commodities. In short, AB is the production possibilities curve of country
A. Similarly, A1B1 is the production possibilities curve of country B.
Fig.No. 3.6 : Trade under constant Opportunity Cost

(Countries of Equal Economic size)
From these two curves, we know that country a has a comparative advantage
in the production of cloth over country B, while country B has a comparative
advantage in the production of wheat over country A. Evidently, country A will
specialise in the production of cloth and country B will specialise in the
production of wheat for purposes of exchange in international trade. Both the
countries will exchange commodities in the ratio indicated by the dotted price
line AB1. Assuming that both the countries want to consume the two commodity
bundles shown by point D for country A and by point D1 for country B, country
A will export CA which is equal to DK quantity of cloth, and import CD (=AK)
quantity of wheat. At this exchange ratio, country B exports WB1 which is
equal to D1K1 quantity of wheat and import WD1 quantity of cloth, which is
equal to B1K1. Since the amount of cloth which A exports (DK) exactly equals
the amount of cloth that B imports (WD1) and the amount of wheat which B
exports (WB1) equal the amount of wheat which A imports (CD), AB1 is the
equilibrium terms of trade line. It is so because, at the terms of trade or
exchange-ratio shown by the slope of AB1, the balance of trade of both the
countries is in equilibrium, i.e., the total value of imports equals the total value
of exports of each one of the two countries.
Both the countries will gain from trade. The production possibilities curve AB
of country A shows that in autarky, AC quantity of cloth can be exchanged for
CC1 quantity of wheat in the domestic market, but under free trade in the
international market AC quantity of cloth is exchanged for CD quantity of wheat.
Consequently, as result of trade, country A obtains C1D (=CD-CC1) additional
quantity of wheat which is the net gain to the country from trade. Similarly, the
gain of country B from trade is the W1D1 (=WD1-WW1) quantity of cloth.
Specialisation in both the countries will be complete if both the countries are
of approximately equal size. If the two countries are of unequal size, i.e., one
country is very small and the other one very large, then only partial specialisation
will take place in the large country, while the small country will practise complete
specialisation.
Fig.No.3.7 : Countries of Unequal size
Figure 3.7 illustrates the situation where one country is very small and the other
country is very big. As indicated already, small country will adopt complete
specialisation, while large country will adopt only partial specialisation. In such a
situation, the gains accruing from international trade between these two countries
will be appropriated by the small country. It is so because the international
exchange ratio will coincide with the pretrade domestic exchange ratio of the
larger country which continues to produce both the commodities, since even
after the small country has specialised completely in one commodity, there is
still some excess demand for this commodity which is satisfied by production
under the domestic cost conditions in the large country. Consequently, the small
country can buy or sell any quantities at the domestic exchange ratio of the
large country. The small country is just a price - taker. In this situation, the
smallness of the country becomes a boon for the small country.
We take the example of two countries, say India and Bangladesh; the former
is a larger country; while the latter is a small one. Bangladesh commands
comparative cost advantage in the production of jute cloth. Hence, she
specialises completely in the production of jute cloth. However, being a small
one, her total production of jute cloth is insufficient to meet her own domestic
and India’s demand for jute cloth. As a result, India has to produce some jute
cloth in order to meet part of her demand. She cannot, however, produce
some jute cloth domestically, unless it is exchanged against wheat at her
pretrade domestic exchange ratio. In this situation, Bangladesh will sell (export)
her jute cloth to India and will buy (import) from India wheat at India’s pretrade
domestic exchange ratio represented by the slope of India’s production
possibilities curve.
In the figure 3.7, BD is the production possibilities curve of Bangladesh, while

IA is the production possibilities curve of India. Suppose Bangladesh produces
at point “B” specialising completely in the production of jute cloth. She trades
part of her jute cloth production against imports of wheat from India, permitting
her to consume the commodity combination at point “R”. To achieve this
commodity consumption pattern, Bangladesh imports BQ quantity of wheat
from India in exchange for QR quantity of jute cloth. India consumes at point S
where her total consumption of jute cloth exceeds the total imports of jute
cloth available to her from Bangladesh. Consequently, she supplements the
total imports amounting TU from Bangladesh with UV amount of jute cloth
produced in the country.
Thus, India’s production point is U where she produces UV amount of jute

cloth and 150 units (OV) of wheat. While the small country Bangladesh,
completely specialises in the production o jute cloth and appropriate the entire
gains from trade, India produces both the commodities and imports jute cloth
from Bangladesh at her domestic exchange ratio.
Graham has made interesting observation. The smallness of a country is an

advantage rather than disadvantage in one respect. A big country has to
diversify its production to meet various domestic needs, while a small country
can specialise with relative ease. There is an additional advantage. A small
country cannot absorb all the exportable surplus of the big country, but the
rich country can. Thus, being small is beautiful.
3.1.6 TRADE UNDER INCREASING OPPORTUNITY COST

We shall discuss about trade between two countries under increasing opportunity
cost. In the real world, constant cost is not possible and it is analysed only
under the assumptions of fixed factor proportions and equal efficiency in
producing the relative outputs of the two goods. Factors of production are not
combined in any fixed proportions, but only in varying proportions. Further, many
factors of production are specialised in particular uses, being suited to the
production of certain commodities only. Such factors are referred to as product-
specific factors. The existence of a product-specific factor of production is
responsible for the phenomenon of increasing costs in production. Where
increasing costs operate in production, the slope of the PP curve varies
throughout its length showing changes in the relative unit costs of production of
the two commodities. Consequently, the relative prices commodities will also
very and the price at which one commodity will be exchanged for another cannot
be determined by the production possibilities curve alone. In order to know the
actual exchange ratio at which the two commodities will be exchanged, the
demand conditions will have to be taken into account.
This situation is illustrated in the figure 3.8. In the figure, the production
possibilities curve of Country A has been shown by AB while the domestic
price or exchange ratio is shown by the slope of price line KL which is tangent
to the production possibilities curve at point P. The condition of simultaneously
tangency between the price line, the production possibilities curve and the
community indifference curve shows that the rate of commodity substitution
in consumption equals the rate of commodity substitution in production.
This situation ensures equilibrium in the sense that there is no excess supply
or excess demand for both the commodities in the country. Suppose production
takes place at point P1 on the production possibilities curve of the country,
there will be excess supply of Y commodity, say cloth and short supply or
excess demand of X commodity, say, wheat in the market. The unsold supply
of cloth and the unsatisfied demand for wheat would necessitate a change in
the relative prices of the two commodities, so as to keep the production of the
two goods at point P. If the demand conditions do not change, producers will
have to adjust their production of the two goods, according to the demand for
the two commodities. Since the factors of production are getting higher
remuneration in the wheat growing industry, resources will be released from
the cloth making industry and will be employed in the production of wheat.
Eventually, equilibrium will be achieved at point P where the rate of commodity
substitution in production is equal to the price ratio shown by the slope of KL.
Fig.No.3.8 : Simultaneous tangency between PP curve, Price Line and

Community Indifference curve showing equilibrium
AB : Production possibilities curve of the country

KL : Domestic price or exchange ratio (slope of price line)
CIC2 : Community indifference Curve No.2
P : Point of Tangency (simultaneous : AB, KL, CIC2)
P1 : Point of Tangency at some other level in PP curve
X axis : Wheat
Y axis : Cloth
With the help of simultaneous tangential point of production possibilities curve,

price line and the community indifference curve as indicated above in the
figure 3.8, it will be easy to demonstrate and phenomenon of trade between
two countries having increasing opportunity cost.
We have already studied that the production possibilities curve under increasing
opportunity costs is concave to the origin because when a country specialises
in the production of one commodity, in which it possesses comparative
advantage, its opportunity costs increase.
In figures 3.9 and 3.10, countries A and B are taken for illustration. The
production possibilities curves of countries A and B are shown by AB and CD
respectively. Both the countries have come to equilibrium under autarky
condition at points M and N respectively where the PP curve, price ratio line
and community indifference curve have been tangential at the same point. In
the figure 3.9, depicting the curves of country a, EF is the price ratio line. At
point M the country has come to equilibrium where consumption and production
have become equal. In the case of country B, GH is the price ratio line and it
has come to equilibrium at point N. Before commencement of trade between
these two countries, country A remains at M point producing respective
quantities of wheat and cloth and country B remains at point N producing
respective quantities of wheat and cloth.
Now, both the countries A and B enter into trade in these two commodities,
viz., wheat and cloth. From the shape of the PP curves of the two countries,
we can easily find out that country A has specific advantage in the production
of cloth and country B in the production of wheat. So, they specialise in the
same manner for purposes of trade.
After the commencement of trade, the international exchange ratio is

represented by the curve TT for country A and for the country B, international
exchange ratio is represented by the curve T1T1. Curves TT and T1T1 are
parallel. With the international exchange ratio TT, country A will increase
production of cloth, as cloth has become dearer in terms of wheat in the
international market. In the new situation, equilibrium in country A will be achieved
at point R where the international terms of trade line TT is tangent to country’s
production possibility curve. Similarly, equilibrium in country B will be attained
at point S where the international terms of trade line T1T1 is tangent to her
production possibility curve. Country A will exchange part of her cloth of wheat
and reach the new consumption point K. Similarly, country B will consume at
point L. In equilibrium, the exports of RV amount of cloth from country A is
equal to country’s imports of LW amount of cloth. Similarly, the exports of SW
amount of wheat from country B equal the imports of VK amount of wheat
made by country A.
Fig.No. 3.9 : Trade with Increasing Opportunity Cost - Country A
Fig.No. 3.10 : Trade with Increasing Opportunity Cost - Country B

From the figure 3.9 and 3.10, we will be able to infer that the two countries A
and B benefit by entering into international trade. Both the countries are able
to consume more of the two commodities, viz., wheat and cloth than what
they were doing before entering into trade. Hence, it is advantageous to
specialise in the production of commodities in which each country is more
efficient. But, under increasing opportunity cost, countries can specialise only
partially in the commodities in which they have special advantage of
comparative cost. This is due to the fact that the producers will not be willing
to operate under decreasing returns, while producing more with specialisation.
After all, increasing opportunity cost means decreasing returns in production.
Hence, the gains from trade are less than that under complete specialiation.
Further, the law of comparative costs if valid only under increasing opportunity
costs. n a two-goods world, if one country is more efficient in producing both
goods than another country, it profits by concentrating on the product in which
it has a greater comparative advantage and buying the goods in which it has a
comparative disadvantage. The basic criterion is that with trade it gets a higher
price for its speciality or pays a lower price for the commodity in which it is
relatively not so productive.
Illustration of increasing opportunity cost of Two countries in the same base
We can also illustrate the results of trading of two countries with different
PPCs on a single base and show that the principle of comparative advantage
is indicated. We can also come to the same conclusion that there cannot be
complete specialisation under increasing opportunity cost. In the figure 3.11
given below, the production possibilities curves of two countries, say, India
and Malaysia are drawn on the same base.
In this example, the production possibilities curves of India and Malaysia are
given. It is presumed that factor endowments of India favour greater attention
to the production of textiles and factor endowments of Malaysia favour
production or rubber. The slope of PP curve of India shows that it can produce
more textile goods and less rubber with a given amount of factors. The slope
of PP curve of Malaysia shows that she can produce more rubber and less
textiles with a given amount of factors. The domestic exchange rates of the
two countries clearly show that rubber will be cheater in Malaysia (in terms of
textile goods) and textiles will be cheaper in India (in terms of rubber).
Y
Y
H
M
G I
TEXTILES
J
P
K
E
X
O A B C M D R
RUBBER
Fig.No.3.11 : Trade with Increasing Opportunity Cost

(Points of specialisation)
LM : PP Curve for India

PR : PP Curve for Malaysia
HK : Common Tangent point for both
I : Autarky position for India
J : Autarky position for Malaysia
Points H and K are points of specialisation for India and Malaysia respectively.
In the figure 3.11, I is the autarky point for India and J is the autarky point for
Malaysia. These points are arrived at with the help of the community indifference
curves. It is obvious that since comparative advantage exists with India and
Malaysia for textiles and rubber respectively, both of them will be profited by
trade. It is clear that India will export textile goods and Malaysia will export
rubber.
As both countries will have increased demand for the product of their
specialisation, they will produce more. As more is produced, the opportunity
cost of both textiles and rubber will increase in the respective countries. Trade
between two countries will establish a new cost structure. Trade will go on till
opportunity costs are equal to the international exchange ratio. This is the
point of specialisation when 1:1 ratio between the rubber and textiles is
established; there shall remain no profit in trade beyond that.
A tangent on production possibilities curves of both countries cuts both curves

at H and K points. These are the point of specialisation for India and Malaysia.
India will increase the production of textiles and reduce that of rubber, while
Malaysia will do the opposite till the ratio 1:1 is reached.
An analysis of the figure 3.11 indicates the following:
With reference to India

Textile production OM (formerly OG - Now more)
Textile consumption OE
Textile exports EM
Rubber production OA (formerly OB - Now reduced)
With reference to Malaysia
Rubber production OD (formerly OC - Now increased)
Textile production OE (formerly OP - Now decreased)
Rubber exports AD
India’s textile exports EM exchange for AD exports of Malaysia. Thus, welfare

of both countries increases, because imports are received at cheaper rate.
3.1.7 TRADE UNDER DECREASING OPPORTUNITY COST (OR) IN

CREASING RETURNS
We know that decreasing opportunity cost is a production situation where the
average and marginal costs of production will decrease, as the output
increases; in other words, it is a condition of increasing returns in production.
Decrease in unit cost of production is possible when the firm exploits fully its
internal economies or external economies of scale of production. According
to Kindleberger, “increasing returns based on internal economies have always
played a role in discussion of internal trade theory and policy, usually in
connection with infant industry argument for a tariff”.
We have studied already that under increasing returns or decreasing

opportunity cost, the PP curve of the country will be convex to the origin. Figure
3.12 exhibits production possibilities curve of country A, producing cloth and
wheat. It is shown by the line AB. The pre-trade equilibrium of the country in
production takes place at point P where the domestic price-ratio line GH is
tangent to the production possibilities curve. In equilibrium, the country
produces OC quantity of cloth and OW quantity of wheat. If there are internal

economies in the production of cloth, the country will utilise the same fully and
use all its resources in the production of OA quantity of cloth without any wheat.
On the other hand, in internal economies are available in the production of
wheat, all the domestic resources will be devoted to the production of wheat
and it will produce OB quantity of wheat and no cloth at all. In case internal
economies are equally available in both industries, the pattern of production
will be decided by the domestic exchange ratio (slope of the pre-trade price
ratio line) for an open economy.
Suppose the production of these two commodities are taking place in two
countries under increasing returns or decreasing cost, the PP curves of the
two countries will be convex to the origin. Figure 3.13 exhibits the PP curves
of two countries, producing wheat and cloth. The PP curves of the two countries
A and B are shown by curves AB and A1B1. Let us assume that the domestic
exchange ratio is determined by the slope of the price-ratio line GH and CD in
the two countries. Consequently, in autarky equilibrium in production in country
A takes place at P and in country B at point P1 where the domestic exchange
ratio lines GH and CD tangent to the PP curves AB and A1B1.
The domestic exchange ratios shown by the slopes of price-ratio GH and CD

show that country A has a comparative advantage over country B in the
production of cloth, while country B has a comparative advantage over country
A in the production of wheat. If the international price-ratio line is AB1, country
A will completely specialise in the production of cloth as the flatter international
exchange ratio line AB1 shows that cloth for her is dearer in the international
market. For country B, cloth is cheaper in the world market as the slope of the
international price-ratio line AB1 is steeper than the slope of domestic price-
ratio line CD. Consequently, country B will specialise in the production of wheat.
Fig.No. 3.12
Fig.No. 3.13
After trade takes place, complete specialisation will be attempted in both the
countries. Country A will export cloth to country B and import wheat from her,
while country B will export wheat to country A and will import cloth from country
A. The equilibrium point in consumption of both the countries will lie somewhere
on the international exchange ratio line AB1 and will represent the gain from
trade for both the countries.
CHECK YOUR PROGRESS

1. Haberlers opportunity costs theory explains the doctrine of comparative
costs interms of the production possibility curve.
2. The slope of the production possibility curve is its marginal rate of
transformation (MRT)
SUMMARY
The opportunity costs theory says that if a country can produce either commodity
X or Y, the opportunity cost of commodity X is the amount of the other commodity
Y that must be given up in order to get one additional unit of commodity X.
Thus the exchange ratio between the two commodities is expressed interms
of their opportunity costs.
GLOSSARY
Production possibility curve : It shows the various alternative combination
of the two commodities that a country can produce most efficiently be fully
utilizing its factors of production with the available technology.
MRT : The slope of the production possibility curve is its marginal rate of
transformation.

MODEL QUESTIONS
1. Explain the opportunity cost theory?
2. Critically discuss the opportunity costs theory of international trade.
BOOKS FOR REFERENCE
1. M.L.Jhingan, International Economics, Vrinda Publications (P) Ltd.
2. D.M.Mithani, International Economics, Himalaya Publishing House.
UNIT 4
MODERN THEORY INTERNATIONAL
TRADE
STRUCTURE
Overview
Learning Objectives
4.1 Modern theory
4.1.1 Hecksher Ohlin theory of International trade
4.1.2 Assumption of the theory
4.1.4 Superiority of Heckscher - Ohlin Theory over classical theory
of International trade
4.1.5 Criticism of Hecksher - Ohlin theory
Summary
Glossary
Model Questions
Books for reference
OVERVIEW
In this unit, you are going to learn about the meaning of Hecksher Ohlin theory
of International trade. You will also further learn about the assumption of the
theory. Hecksher Ohlin theory is also explained with the diagram.
LEARNING OBJECTIVES

Ø explain the meaning of Hecksher Ohlin theory of International trade
Ø describe the assumptions of the theory
Ø explain the Hecksher Ohlin theory with the diagram
4.1 MODERN THEORY
4.1.1 HECKSCHER – OHLIN THEORY OF INTERNATIONAL TRADE
The Heckscher - Ohlin is based on the premise that international trade between
two countries takes place because of different countries have different factor
44 Modern theory International trade
endowments. Some countries have more capital relative to labour and some
other countries more labour supply. The H-O theory of international trade
maintains that a country which has relatively abundant capital would specialise
in and export capital - intensive goods; and a country with relatively abundant
supply of labour would specialise in and export labour - intensive goods.
According to Heckscher and Ohlin, among the factors which cause differences
in the commodity prices between different countries, factor endowments of
different countries exhibit great variations. While some countries like Australia
and Argentina are endowed with abundant land, others like Germany and U.K.
possess relatively large accumulation of capital. yet, some other countries
like India and China, command abundant labour force. Variations in factor
supplies will cause similar variations in factor prices. Countries endowed with
abundant low interest rate, while in the densely populated countries, wages
will be relatively low. However, relative differences in factor prices are not enough
to guarantee relative differences in commodity prices. In addition to differences,
in factor prices, it is essential that the factor combinations should be required
for the production of different commodities. It means that the production
functions must be different for different commodities. Thus, the factor
proportions theory rests on the following two conditions.
(i) There must be differences in the relative factors endowments of different

countries. (ii) Factors intensities or factor combinations required for the
production of different commodities must be different.
These two conditions together with the general theory of pricing from the core
of the Heckscher - Ohlin theory of international trade.
4.1.2 ASSUMPTION OF THE THEORY

1. The analysis is based on two countries, two commodities and two
factors of production. Hence, it called a two-by-two-by-two model. The
two of production are capital and labour.
2. There is perfect competition in commodity as well as factor markets
in both the countries.
3. There is full employment of resources.
4. There is perfect mobility inside the country (hence one price rules for
one commodity in a country) but not between two countries (Hence,
prices of the same commodity differ in two countries).
5. Both the countries use the same technology.

6. There are quantitative differences in factor endowments in different
regions, but qualitatively they are homogenous.
7. The production functions of the two commodities have different factor
intensities, i.e., labour - intensive and capital intensive.
8. The production functions are different for different commodities, but
are the same for each commodity X is different from commodity Y.
But, the technique used to produce commodity X in both the countries
is the same, and the technique used to produce commodity Y in both
countries is the same.
9. There are no transport costs
10. There is free and unrestricted trade between the two countries.
11. There are constant returns to scale in the production of each commodity
in each region.
12. Tastes and preferences of consumers and their demand patterns are
identical in both countries.
13. International transactions are confined to only commodity trade. The
theory ignores transactions arising from capital movements,
remittances of interest or dividends and other invisible items in the
14. Partial specialiation assumed. It is advanced as the proof of the theorem
also.
15. Technology remains constant and fixed. Technological information is

costless and ubiquitous.
4.1.3 Explanation and Illustration of Heckscher - Ohlin Theory.
With the above stated assumptions, Hecksher and Ohlin stated that the
immediate cause of international trade is the difference in relative commodity
price caused by differences in relative demand and supply of factors (factors
prices) as a result of differences in factor endowments between the two
countries. Fundamentally, the relative scarcity of factors – the shortage of
supply in relation to demand – is essential for trade between two regions.
Commodities which use large quantities of scarce factors are imported
because their prices are high while those using abundant factors are exported
because their prices are low.
In this context, the H-O theorem is explained in terms of two definitions :
(1) Factor abundance (or scarcity) in terms of the price criterion; and (2)
Factor abundance (or scarcity) in terms of physical criterion. We discuss
these one by one below :
According to price criterion, a country having relatively cheap capital and

relatively costly labour is regarded as relatively capital abundant, irrespective
of its ratio of total quantities of capital to labour in comparison with the other
country. In symbolic terms, when
 PC   PC 
 PL  <  PL 
x y
Here, P stands for factor price and C for capital, L for labour, x and y for the
two respective countries. In this example, country x is relatively capital abundant.
Hence, country x will produce and export the capital intensive goods and
import the labour - intensive goods. Country y will produce and export labour
intensive goods and import capital intensive goods, as labour is relatively cheap
in country y compared to country x.
According to physical criterion, strictly implying relative factor endowments in

physical quantities, a country is relatively capital abundant only if it has got a
greater proportion of capital to labour, as compared to other country. To put it,
symbolically,
c C 
 L  >  L 
x y
Here, country x is relatively capital abundant, whether or not the ratio of the
prices of capital to labour is lower than country y.
Ohlin chooses the price criterion of determining the relative factor abundance,
but he also lays down that the difference is factor prices is due to the difference
in relative endowments of the factors between countries. Factor price structure
will be different in two countries when the factor endowments are in differing
proportions.
The basic contention of Heckshcer - Ohlin theory is that intensity difference in

the production function of two goods, in conjunction with the differing factor
endowments of the two countries, accounts for the international differences
in the relative commodity prices. Thus,
 PC   PC   PL   PL 
 PL  <  PL  and  PC  >  PC 
 x  y  y  x
If relative factor endowments are identical in two countries and commodity

factor intensities are also the same, there will be no comparative price or cost
differences; hence no theoretical basis for international trade.
Price Criterion : Verification of H-O Theory
The figure 6 illustrates and also verifies the H-O theory on the basis of price
criterion. Let us assume that there are two countries, named as country 1 and
2. Labour - intensive commodity has been taken in the horizontal axis; and
capital - intensive commodity has been taken in the vertical axis. The factor
price-ratio line of country 1 is AB while that of country 2 is A3B3 which is equal
to A2B2. The slope of the factor price - ratio line AB of country 1 is greater than
the slope of the factor price-ratio line of country 2 showing that capital is relatively
cheap in country 1, while labour is relatively cheap in country 2. Suppose, the
two countries produce function for each commodity is identical in both the
countries, but it is different for the two commodities. Factor price - ratio line
AB is tangent to SS isoquant of stainless steel at point ‘a’ showing that country
1 produces a given quantity of stainless steel (one unit of stainless steel) by
combining OK amount of capital with OL quantity of labour. In terms of cost,
however, this factor combination is identical to OA amount of capital and zero
amount of labour amount of labour. In the words, in terms of cost, the OL
amount of labour is equal to OK amount of capital. Thus, the total cost of
producing one unit of stainless steel in terms of the amount of capital in
country 1 is OA. Factor price ratio line A2B2 of country 2 is tangent to SS
isoquant at point ‘b’ showing that one unit of stainless steel in country 2 is
produced with the combination of OK1 quantity of capital and OL1 quantity of
labour. If labour is converted into capital then OL1 amount of labour is equal to
A2k1 amount of capital. Thus, the total cost of producing one unit of stainless
steel in terms of capital is OA2.
In the same method, we can calculate the total cost of producing one unit of
cotton in country 1 is OA amount of capital, while in country 2, it is O A 3
amount of capital. Line A3B3 is parallel to the factor price-ratio line A2B2 of
country 2. The factor price-ratio line A3B3 is tangent to C1C1 isoquant of cotton
at point ‘D’ showing that one unit of cotton is produced by combining OK3
amount of capital with OL3 amount of labour. The OL3 quantity of labour is
equal to A2K3 quantity of capital. Thus, the total cost of producing one unit of
cotton in terms of capital is OA3 (= OK3 + K3 A3) in country 2.
In country 2, production of one unit of cotton requires only OA3 amount of

capital which is less than OA2 amount of capital. Thus, the production of cotton
because it is a labour - abundant country. Similarly, country 1 should produce
and export stainless steel as the production of this is capital - intensive and
country is capital - rich.
Fig.No. 4.1 : Verification of H-O Theory (Price Criterion)
Physical criterion : Verification of H-O Theory

Next, we shall pass on to the study of verification of H-O theory as per physical
criterion. We have already studied that according to this criterion, a country is
said to be relatively capital abundant, if and only if, it is endowed with a higher
proportion of capital to labour than the other country.
Imagine country A is capital-abundant and country B is labour - abundant in
physical criterion. Then, accordingly H-O theory, country A will produce capital
0- intensive commodity, say, steel and country B will produce labour - intensive
commodity, say, cloth. If both the countries produce steel and cloth in the
same proportion, their production points will lie on the production possibilities
curve of the respective countries. This has been shown in the figure.
Fig.No.4.2 : Verification of H-O Theory (Physical Criteria)

According to the figure, country A’s production possibility curve is SS and
country B’s production possibility curve is CC. The former producer steel and
the latter produces cloth. If both the countries produce steel and cloth in the
same proportion and production occurs along OR, the country A would be
producing at ‘M’ and country B would be producing at N and both the points lie
in the respective PP curves as shown in the figure. Since at point ‘M’ the slope
of country A’s production possibility curve is more steep than the slope of
production possibility curve of country B at point N, it will imply that production
of steel is cheap in country A and production of cloth is cheap in country b. So,
if the production takes place at points M and N, steel can be produced more
cheaply in country A and cloth can be produced more cheaply in country B.
Since country A is capital -abundant and the production of steel is capital -
intensive, country A will produce steel. Country B will produce cloth, as this
country is labour - abundant and production of cloth is labour - intensive.
From the figure, it is evident that the factor - price line TT is steeper and the
factor - price line T1T1 is flatter and consequently, country A will produce steel
and country B will produce cloth, as the former is capital - abundant and the
latter is labour - abundant.
But the above analysis of physical terms does not show that the capital - abundant
country will export the capital - intensive commodity, viz., steel and the labour -
abundant country will export labour - intensive commodity viz., cloth. The
Heckscher - Ohlin theorem will be valid on the basis of this physical criterion
only if the consumption pattern in both the countries is identical and the income
elasticity of demand for each commodity equals unity. If the demand conditions
are different in two countries, the conclusion that capital - abundant countries
will export capital - intensive commodity and labour - abundant countries will
export labour - intensive commodities cannot hold true or sustained.
It may be possible that the demand conditions in the two countries may be
such that the above stated tendency based on H-O theorem may be reversed
or nullified. In other words, on the basis of supply (cost) conditions alone, we
cannot reach the infalliable conclusion that the two countries would necessarily
engage in trading and that the actual direction of trade would follow the direction
expected on the basis of cost considerations alone. Demand reversals may
change the direction of trade and country A in our illustration may import steel
(rather than export) and country B may import cloth rather than exporting it, if
the community indifference curves in the two countries are such that lead to
high price of steel in country A and high price of cloth in country B. Possibility
may also exist that the pre-trade domestic exchange ratios in the two countries
are equal eliminating any a scope for the trade. Consequently, both countries
will remain self-sufficient.
The sum and substance of the analysis is that everything depends upon
demand factors. This gives rise to two possibilities : (i) If the consumption
bias and the production bias are towards the same direction, then country A
would import rather than export steel and country B would import rather than
export cloth. The Heckscher - Ohlin prediction would then the invalid. (ii) If the
consumption and production biases are in opposite direction, then the
Heckscher - Ohlin prediction will be valid, i.e., country A would export steel
and country B would export cloth. Let us illustrate these two cases.
Consumption and Production in Opposite direction

(Validating Heckscher - Ohlin theory)
Study the figure. SS and CC are the production possibilities curves of country
A and country B respectively; the former capital - abundant and the latter labour
- aboundant. Country A produces steel which is capital - intensive and country

B produces cloth which is labour - intensive.
After the establishment of trade between the two countries, country A’s
production shifts to point A (towards greater production of steel), and country
B’s production shifts to point B (towards greater production of cloth). This
means that the capital abundant country A specialises in the production of
capital intensive commodity steel and the labour - abundant country B
specialises in the production of labour - intensive commodity cloth. There is
greater degree of specialisation, but by no means complete specialisation in
the two countries, because of the diminishing returns to scale conditions in
the two countries in respect of the goods.
The line PP stands for the international terms of trade line, which is also the
relative factor price ratio line after trade is established between two countries.
Note that factor prices will be equalised as a result of trade. If, and only if, the
demand biases in the two countries are such that we have an indifference
curve like IC in the figure. the Heckscher - Ohlin theorem will hold good. The
two countries produce at points A and B, but consume at point C1. It is important
that the consumption point, such as point C1 amount of steel. Thus, the capital
surplus country is exporting capital-intensive commodity and it is importing
labour-intensive commodity and it is importing capital - intensive commodity.
Hence, Heckscher - Ohlin theorem is valid in this case.
Fig.No. 4.3 : Validating Heckscher - Ohlin Theory

In this context, it should be understood that it is by no means necessary that

the taste pattern in the two countries must be identical. In the figure 4.3, we
have made that assumption in drawing a common indifference curve IC both
for country A and country b, but it is not necessary. One can feel free to assume
that the taste patterns in the two countries are different, if that is more realistic.
For instance, in our figure 4.3, we have also drawn ICA and ICB which represent
different utility patterns in country A and country B. This would only mean that
country A is consuming at point R while it produces at point A, and that country
A is consuming at point R while produces at point A, and that country B is
producing at point B and consuming at point T. Nevertheless, country A exports
steel (equal to AH amount) and imports cloth (equal to HR amount); and
country B export FB amount of cloth and imports TF amount of steel. therefore,
as long as the consumption points lie to the right of where production is taking
place in country b, the H-O theorem regarding production, specialisation, as
well as commodity composition of exports and imports by countries would
perfectly hold good.
Consumption and production in the same direction (Invalidating

Heckscher - Ohlin theory)
Nextly, we shall consider the case of consumption and production which are
biased in the same direction, leading to invalidation of H-O Theory.
The figure reproduces the same information and production which are biased
in the same direction, leading to invalidation of H-O theory.
The figure reproduces the same information as given in the figure 4.3; but the
demand in country A is biased toward the capital - intensive commodity and
that in country B the demand is biased toward labour - intensive commodity.
Therefore, as a result, country A produces at point A, specialising in the
production of steel. In consumes at point D, given the utility pattern represented
by indifference curve ICA. This means that country A exports EA amount of
cloth and imports ED amount of steel. Therefore, country A which is capital
abundant country is exporting labour - intensive commodity, viz., cloth and
importing capital - intensive commodity - viz., steel. This is in direct conflict
with the Heckscher - Ohlin theory concerning commodity structure of trade.
Likewise, country B specialises in the production of cloth. It produces at point
‘B’, but consumes at point G in response to its utility pattern represented by
the indifference curve ICB. Therefore, it exports BF amount of steel and imports
FG amount of cloth. Once again we notice that country B, which is a labour -
abundant country exports capital - intensive commodity, i.e., steel and imports
labour intensive commodity, i.e., cloth. Evidently, in this case, the H-O theory
is totally overturned.
This is a situation which is called ‘Diamand Reversal’. Here, not only the
consumption and production are in the same direction, but also the
consumption bias more than offsets the production bias.
Fig.No. 4.4 : Invalidating Heckscher - Ohlin Theory
In the figure 4.4, consumption point D lies to the left of production point A in
country A; and in country b, the consumption point G lies to the right of the
production point B. When such a demand reversal takes place, the capital -
abundant country would export labour - intensive goods and the labour abundant
country would export the capital - intensive commodity. The Heckscher - Ohlin
prediction would be invalidated by the demand reversal.
In conclusion we may say that the factor abundant can be defined in two ways
in Heckscher - Ohlin trade model. The two definitions are not equivalent. Only
according to the price criterion, the prediction of the model would be valid. If
the physical criterion is used, the prediction will be valid only if the demand
demand reversal does not take place.
4.1.4 SUPERIORITY OF HECKSCHER - OHLIN THEORY OVER

CLASSICAL THEORY OF INTERNATIONAL TRADE
Heckscher - Ohlin theory does not contradict the Ricardian theory. It rather
supplements it as it attempts to investigate the basic forces determining the
comparative advantage of one country over the other. However, H-O theory
makes some departure from the traditional theory and in the process, effects
significant improvements upon the latter in following respects.
1. The H-O theory goes to the very root of all trade and therefore, comes to the
conclusion that international trade is only a special case of inter-regional or
internal or domestic trade, as indicated earlier. Both inter-regional and
international trade basically belong to the same species. The fact that
international trade is not fundamentally different from inter-regional or domestic
trade can be proved by a few illustrative examples. Before April 1, 1935, Burma
(Mayanmar) was a part of India and other regions of India used to get teak-
wood, kerosene, and rice from Burma region and set to Burma manufactured
goods like cloth, sugar, metal goods etc. After April 1, 1935, Burma as separated
from India and overnight what was still then domestic trade became international
trade. Yet, Indian imports and exports to Burma remained practically the same
as before. Similar was the case with Sind and Western Punjab which became
part of Pakistan after 15th August 1947. Inter-regional trade became
international trade after separation of Pakistan. This shows that there is no
fundamental difference between inter-regional and international trade. Both
belong to the same species and therefore there is not necessity of a separate
theory of international trade as was thought by the classical school.
2. H-O theory is based on general theory of value, while the classical theory is
biased upon labour theory of value. The H-O theory takes into account both
demand and supply forces for determining specialisation and pattern of trade.
In contrast, Ricardian theory was very deficient and one-sided. It had relied
exclusively upon the supply factors and overlooked completely the demand
forces.
3. H-O theory is more realistic than the classical theory as the former theory
takes into account differences in productivity of both labour and capital, whereas
classical theory considers differing productivity of labour only in the two trading
countries.
4. The H-O theory has made the difference in factor endowments of different
countries the basis of international trade, whereas the classical theory takes
no note at all of differences in factor endowments in different countries.
5. Another important feature of H-O theory is that it lays down a permanent

basis for international trade. The classical theory implicitly relates the
comparative differences in costs to differences in skill and efficiency of labour.
Over a long period, there can be international transmission of technical
knowledge from one country to another and all differences in cost due to skill,
efficiency and technology are likely to be eliminated. It implies that the trade
between two countries may come to an end in the long run. Kevin Lancaster
has however pointed out that the trade between countries is not likely to come
to an end even if there is perfect transmission of knowledge and techniques
because the differences in factor endowments will continue to persist even in
the long run. since the factor movements from one country to the other cannot
take place on such a scale that the factor endowment gap can be completely
bridged, the comparative cost differences will continue to exist and hence
there can be permanent exchange of commodities. thus, H-O model lays
down a permanent basis for international trade.
6. A highly significant difference between the classical and H-O theories is

that former approach consists primarily of propositions related to the relative
product prices. the latter, on the contrary, deals with propositions related to
the relative factor prices.
7. The traditional theory emphasises upon the gains accruing to countries

from foreign trade. Therefore, the classical theory has useful welfare
implication. On the other hand, the Heckscher - Ohlin theory stresses on the
analysis of bases of trade between two countries. The contribution of H-O
theory is mainly on the positive economics.
8. The classical theory takes into account only the single factor, labour, and
attributes the comparative differences in costs to qualitative differences in
costs. The H-O theory on the other hand, deals with two factors viz., labour
and capital. It assumes an absence of qualitative differences in them. The
international trade and specialisation results on account of quantitative
differences in factor proportions and factor intensities.
9. The classical theory is based on the differences in production of specified

commodities between the two trading countries. On the otherhand, H-O theory
gives prominence to differences in their production functions.
10. According to Haberler, the H-O theory is a location theory which highlights
the importance of the space factor in international trade, while the classical
theory regards the different countries as spaceless markets. Thus, the former
is superior to the latter.
11. The H-O model is more realistic than the classical theory in that the former
leads to complete specialisation in the production of one commodity by one
country and of the other commodity by the second country when they enter
into trade with each other. By contrast, the trade between two countries may
or may not lead to complete specialisation in the classical theory.
It is clear from the above discussion that the modern theory of international
trade has made not only a highly significant break from the traditional analysis,
but also registered a considerable improvement upon it.
4.1.5 CRITICISM OF HECKSCHER - OHLIN THEORY

The H-O theory has been found to be more exact, precise, scientific and
analytical superior to the earlier approaches to the theory of international trade.
Still, it has certain deficiencies for which it has been criticised by many writers.
The theory has been criticised on the following grounds :
1. Over - simplified and Static analysis : This theory is based upon highly over-
simplifying assumptions of perfect competition, full employment of resources,
identical production function, constant returns to scale, absence of transport
costs and absence of product differentiation. Given this set of assumptions,
the whole model becomes quite unrealistic. Further, the H-O model assumes
fixed quantities of factors of production, given production functions, incomes
and costs. It means the theory investigates the pattern of international trade
in a static setting. The conclusions drawn from such an analysis are simply
not relevant to a dynamic economic system.
2. Factors are not identical or homogenous : The theory assumes the existence
of identical and homogeneous factors in the two countries, which can be
measured for calculating factor endowments rations. But in reality, no two
factors are homogenous qualitatively between countries, and even one factor
is of various types. For instance, labour, both skilled and uskilled, is of various
types. Similarly, capital goods take many forms and also perform the tasks of
labour when they are labour - saving. It is not possible in the real world no
measure factors of differing varieties. This may create complications in the
measurement and comparison of costs and the determinations of trade pattern.
3. Production techniques are not homogenous : Another defect in H-O model

is the assumption of homogenous production techniques for each commodity
in the two countries. For instance, textile goods may be produced with
handlooms which require more labour and less capital; or with powerlooms
with smaller number of workers. In such a situation, trade may not follow the
Ohlin pattern.
4. Tastes and Demand patterns are not identical : The theory is based on the
assumption that tastes and demand patterns of consumption in both countries
are identical. This is highly unrealistic. Tastes and demand patterns of
consumers of different income groups are different. Moreover, with inventions
taking place in consumers’ goods, changes in tastes and demand patterns of
consumers also occur even among developed countries. Commodities which
consumers demand in USA are different from commodities demanded by
consumers in Greece or Germany.
Consequently, tastes are not identical in trading countries.
5. No constant Returns : Another unrealistic assumption in the theory is

‘Constant Returns to Scale’ in production. In actuality, country having rich factor
endowments will have the advantages of economies of scale through lesser
production and exports. Thus, there are increasing returns to scale.
6. Transport Costs influence trade : This theory does not consider transport
costs between two countries. This is another unrealistic assumption. In actual
practice, along with transport costs, loading and unloading of goods and other
port charges affect the prices of produced commodities in the two countries.
When transport costs are included, they lead to price differentials for the same
commodity in the two countries which effect their trade relations.
7. Neglect of Product Differentiation : The theory overlooks the role played by

product differentiation in international trade. Even when the productive agents
are identical in two countries, the international trade may still take place due
to product differentiation. For instance, English cutlery finds a market in

Germany and German cutlery is sold in England. Italian ‘Fiats’ are exported to
England, while British ‘Fords’ are sold in Italy. German ‘Volkswagons’ find a
good market in the USA while ‘Peugeots’ are sold in Germany. Similarly,
Japanese machines are sold out in the USA and the American machines are
sold in Japan. In this context, Wijanholds opines that factor prices do not
determine cost. It is rather the commodity prices that determine factor prices.
Prices of goods are determined by their utility to the buyers (the force of
demand) and prices of factors like raw materials, labour, etc., are ultimately
dependent on the demand and prices of final goods, because the demand for
them is the derived demand. So, Wijanholds states that “prices are the only
things we may accept as data. Everything else to be derived therefrom”.
Wijanholds regards both Ricardian theory and Heckshcer - Ohlin theory as

faulty as they related cost to factor prices and neglected the influence of product
differentiation on international trade.
8. Factor proportions and Specilisation: The H-O theory suggests that the
relative factor proportions (or factor endowments) determine the specialisation
in exports of different countries. The capital - abundant countries export capital
intensive goods and labour - abundant countries export the labour intensive
goods. It implies that trade will not take place between such countries or regions
having similar relative factor proportions. But it is not true. A large part of the
world trade is between the U.S.A., the countries of Western Europe, despite
the fact that all of them have a relative greater capital abundance and scarcity
of labour. The H-O theory cannot provide a complete and satisfactory
explanation of trade in such cases. In fact, the specialisation is governed not
only by factor proportions, but also several other factors like cost and price
differences, transport costs, economies of scale, external economies, etc.
The H-O theory was clearly wrong in overlooking these factors.
9. Neglect of factor demand: Another important drawback of the theory is that

it assumes factor prices on the basis of factor - endowments. According to
this theory, in a capital-abundant and labour-scarce country, the cost of capital
will be relatively low, and the wage rates will be relatively high. On this basis,
the United States should have a lower structure of interest rate. But is not so.
In fact, it is higher because of strong demand for capital will be high and
consequently, the rate of interest cost of capital) will also be high. Infact, the
relative factor prices are influenced not only by their supply, but also by the
demand for them. the H-O theory failed to take into account the influence of
demand for factors on their prices.
10. Factor mobility ignored: The theory has assumed that there is absence of
international mobility of factors. This assumption is wrong and also invalid.
Writers like Williams and Levin have pointed out that the international mobility
of factors is actually more than the inter-regional mobility within the same
countries. This is evident from international capital inflows from advanced
countries to such export sectors in the LDCs as petroleum, minerals,
plantations, etc. Similarly, the large scale movement of labour from the Third
World countries to the advanced countries has assisted the latter in enlarging
their production and export. It is therefore, clear that H-O theory takes an
unrealistic assumption of international immobility of factors.
11. Neglect of technological changes: Another wrong assumption is the identical

production function. It implies that the technological conditions in a given country
remain unchanged. This is wrong. There has been continuous improvement
in techniques of production, both in the advanced and the less advanced
countries. The neglect of technological change in H-O theory makes this model
quite inconsistent with actual reality.
12. Neglect of By - Products: H-O theory does not mention anything about the
by-products. In influencing the structure and direction of international trade
sometimes the by-products are more important than the main final product.
13. Partial equilibrium Analysis: Haberler recognised Ohlin’s theory as less
abstract. However, it has failed to develop a general equilibrium concept. It
remain by and large, a part of the partial equilibrium analysis. This theory
seeks to explain the pattern of trade only on the basis of factor proportions
and factor intensities, while ignoring several other influences.
14. It is a vague theory : No doubt, H-O theorem attempted to explain the basic
reason for comparative advantage of the trading countries, yet the theory is vague
and conditional. It depends upon several restrictive and unrealistic assumptions.
In the words of Haberler, “with many factors of production, some of which are
qualitatively incommensurable as between different countries, no sweeping a priori
generalisations concerning the composition of trade are possible.
15. Leontief Paradox Falsified this Theory : Prof. Leontief’s empirical study of
Ohlin theorem, known as Leontief Paradox has led to paradoxical results that
the United States exports labour - intensive goods and imports capital intensive
goods, even though it is a capital - rich country.
CHECK YOUR PROGRESS
A. State whether the following statements are True or False
1. Hecksher - Ohlin theory is known as the modern theory of international trade.

2. According to Ohlin, the comparative cost difference are because of
exchange rate difference.
3. Ohlin introduced price as an element for extending general equilibrium
theory to the international trade.
4. Modern theory of international trade is based on the general equilibrium
approach.
SUMMARY
The modern economists have rejected the classical theory of international
trade primarily on the ground that it was based upon the absolute labour cost
theory of value. These economists have increasingly turned to Bertil Ohlin
theory, which according to them furnishes a more direct, a more national and
a more realistic explanation of the phenomenon of international trade. Modern
theory of international trade is based in a general equilibrium approach. The
theory states that trade results due to difference in relative prices of different
commodities in different countries.
GLOSSARY
Factor endowments : The levels of availability of factors of production in an
area or country

MODEL QUESTIONS
1. Explain the assumption of modern theory of international trade?
2. Describe the Modern theory of international trade.
BOOKS FOR REFERENCE
1. Robert J. Carbaugh - International Economics
2. M.L. Jhingan - International Economics
UNIT 5
MEASUREMENT OF DISTRIB UTION
DISTRIBUTION
OF GAINS FROM TRADE
STRUCTURE
Overview
Learning Objectives
5.1 Gain from Trade
5.1.1 Measurement of gains from trade
5.1.2 Distribution of gains from trade
5.1.3 Gains from International trade
Summary
Glossary
Model Questions
Books for reference
OVERVIEW
In this Unit, you are going to learn the gains from trade. It focuses on the measurement
of gains from trade. It emphasis the distribution of gains from trade.
LEARNING OBJECTIVES
After studying this unit, you are going to learn
Ø the gains from trade

Ø explain the measurement of gains from trade
Ø describe the distribution of gains from trade
5.1 GAINS FROM TRADE
5.1.1 MEASUREMENT OF GAINS FROM TRADE

Economists have adopted various methods to measure the gains from
international trade which are explained as under :
1. The classical method

Jacob Viner points out that the classical economists followed three
different methods or criteria for measuring the gains from international
62 Measurement of distribution of gains from Trade
trade : (1) differences in comparative costs : (2) increase in the lever of national
income ; and (3) the terms of trade. But they often intermixed these methods
without specifying them clearly. We discuss them as under.
Ricardo’s approach
To take Ricardo’s approach first, a country will export import those commodities
in which its comparative production costs are high. The country thus
economises in the use of its resources, obtaining for a given amount thereof
a larger total income than if it attempted to produce everything itself.
Prof. Ronald Findlay in his trade and specialisation (1970) has explained
Ricardo’s approach to the gains from international trade in terms of Fig.1. In the
pre-trade situation, AB is the production possibility curve of a country which
produces two commodities X and Y, given the quantity of labour input. on AB,
the country is in equilibrium at point e. After it enters into trade, its international
price ratio is given by the slope of the line CB. Suppose that it is in equilibrium at
point F on the line CB. If the quantities of X and Y represented by the combination
at F are to be produced domestically, the quantity of labour input will have to
increase sufficiently to shift the domestic production possibility curve up from
AB to A1B1. The gains from trade will thus be measured by BB1 IOB.
Fig.No. 1 Ricardo’s approach
But Malthus criticised Ricardo for greatly over estimating the gains from trade.
In terms of Fig.1, Malthus’s view is that with the shifting of the domestic
production possibility curve to A1B1, F would not be the equilibrium point. Relative
prices along A1B1 would not be more favourable to the exported commodity X
than along CB, so that consumer will prefer a point to the right of F on A1B1
rather than F itself. Hence the gains from trading along CB cannot be measured
by an increase of labour input in the ration BB1IOB. This is because the change
to the right of F on A1B1 is preferable to that on CB.
Prof.Ronald Findlay has modified the Ricardo measure of the gains from trade
using the community indifference curve CI. If the labour input is increased
sufficiently to push the production possibility curve A0B0 instead of to A1B1, the
point G on the CI curve will make each individual as better as he is at the free
trade point F. The gains from trade would, therefore, be equal to BB0IOB instead
of the larger BB1IOB. This measure satisfies Malthus’s criticism of Ricardo.
Mill’s Approach
J.S.Mill analysed the gains as well as the distribution of the gains from
international trade in terms of his theory of reciprocal demand. According to
Mill, it is reciprocal demand that determines terms of trade which, in turn,
determine the distribution of gains from trade of each country. The term ‘terms
of trade’ refers to the barter terms of trade between the two countries i.e., the
ratio of the quantity of imports for a given quantity of exports of a country.
To take an example, in country A, 2 units of labour produce 10 units of X and

10 units of Y, while in country B the same labour produce 6X and 8Y. The
domestic exchange ratio (or domestic terms of trade) in country A is 1X = 1Y,
and in country B, 1X = 1.33Y. This means that one unit of X can be exchanged
with one unit of Y in country A or 1.33 units of Y in country B. Thus the terms of
trade between the two countries will lie between 1X or 1Y or 1.33Y.
However, the actual exchange ratio will depend upon reciprocal demand, i.e.,
“the relative strength and elasticity of demand of the two trading countries for
each other’s product in terms of their own product. If A’s demand for commodity
Y is more intense (inelastic), then the terms of trade will be nearer 1X = 1Y. The
terms of trade will move in favour of B and against country A. B will gain more
and A less. On the other hand, if A’s demand for commodity Y is less intense
(more elastic), then the terms of trade will be nearer 1X = 1.33Y. The terms of
trade will move in favour of A and against B. A will gain more and B less.
Fig.No. 2 Mill’s Approach
The distribution of gains from trade is explained in terms of the Marshall-

Edgeworth offer curves in Fig.2. OA is the offer curve of country A, and OB of
country B. OP and OQ are the domestic constant cost ratios of producing X
and Y in country A and B respectively. These rays are, in fact, the limits within
which the terms of trade between the two countries lie. However, the actual
terms of trade are settled at E the point of inter-section of OA and OB. The line
OT represents equilibrium terms of trade at E.
2. The Modern Approach
In modern trade theory, the gains from international trade are clearly
differentiated between the gain from exchange and the gain from specialisation.
The analysis is explained in terms of the general equilibrium of a closed
economy by taking demand and supply. It is characterised by the tangency of
a community indifference curve with the transformation curve, and the equality
of the marginal rates of substitution between commodities in consumption
and production with the domestic terms of trade or commodity price ratio.
The introduction of international trade permits the realisation of a gain from
exchange and gain from specialisation. When equilibrium is established and
these gains are maximised, the new marginal rate of transformation in
production and the new marginal rate of substitution in consumption are equal
to the international price ratio or terms of trade”. Thus both producers and
consumers gain from international trade by producing and consuming more
than the pre-trade level.
Fig.3 explains the gains from international trade. AB is the transformation

curve representing the supply side and CI0 is the community indifference curve
representing the demand side of an economy. The closed economy (no trade)
equilibrium is shown by point E where the AB and CI0 curves are tangent to
each other and both equal the domestic terms of trade or commodity price
ratio (line) P.
With the introduction of international (or free) trade, the international price ratio
(terms of trade) will be different from the domestic price ratio 9terms of trade).
It is shown as P1 and is steeper than the domestic price ratio P. It means that
the price of commodity X has increased in relation to commodity Y in the
world market. At the international price line P1, the consumers move to point C
on a higher community indifference curve CI1 from point E on the CI0 curve.
This movement from E to C measures the gain from exchange or consumption
gain with no change in production.
Fig.No. 3 The Modern Approach
Since the price of X has increased in the world market, producers increase its
production and decrease that of Y. This leads to movement along the
transformation curve from point E to N where a new international price line P2
is tangent to the AB curve. In other words, at N the marginal rate of
transformation in production equals the international price ratio. The new world
terms of trade ratio P2 is the same as P1 because it is parallel to P1. At N the
country exports KN of X in exchange for KC1 imports of Y.
As a result of increased specialisation in the production of X, there is a shift in

consumption from point C on the CI1 curve to point C1 on the CI2 curve, where
consumers consume larger quantities of both X and Y. This movement from
C to C1 measures the gain from specialisation in production or production
gain. At C1 the marginal rate of substitution and the international price ratio are
equal. Hence the gains from international trade are maximised at points N and
C1 because the marginal rate of transformation in production and the marginal
rate of substitution in consumption are equal to the international price ratio P2.
The total gain from free trade is the sum of the consumption at production
gains and is shown as improvement in welfare from CI0 to CI2.
Increase in National Income. This analysis also explains the increase in the
real income and hence the gains from trade. Point N on the price line P2
corresponds to a higher real income than the pre-trade point E at the price line
P. This is because at the new price line P2, there are production and
consumption gains to the country after trade.
5.1.2 DISTRIBUTION OF GAINS FROM TRADE

Sharing of gains from international trade basically depends on the terms of
trade. If a country has favourable terms of trade, it will claim a larger share in
the distribution.
Distribution of gains from trade is, thus, measured in terms of :
1. Terms of trade, and

2. Domestic cost ration
A country gets a larger share in proportion to its favourable terms of trade.
Gain occurs when cost of production is reduced on account of sepcialisation
process involved in trade. When a country’s domestic cost of production and
terms of trade are settled nearer to the opposite trading country’s cost ratio,
its share in the gains will tend to be larger.
Terms of trade as an Index of International Distribution and Trend of Gain
To measure the trend of gain from trade over a period of time, however, changes
in the terms of trade 9i.e., price ratio of export and imports) have been widely
accepted. Obviously, when terms of trade turn out to be favourable (a rise in
export prices relative to trade), gain from trade may increase. It is, however,
interesting to note that, according to J.S.Mill, a favourable movement of the
terms of trade does not necessarily indicate a favourable movement of the
amount of gain from trade. He pointed out that when the imposition of productive
import duties so operated as to favorably change the terms of trade from the
rest of imports, the resulting advantage was more than offset by the loss of
benefit which had previously accrued from trade in the goods not produced at
home under tariff protection. Under conditions of free trade favourable terms
of trade should imply an increase in the gain. To know the actual gain, however,
it should be related to the costs of production, because change in costs creates
possibilities of reciprocal increase of decrease in gain. If the increase in price
of exports of a country is more than the increase in the domestic goods
production of exported goods, prices of imports remaining constant, its gain
from trade will increase, and vice versa. But if costs increase in the same
proportion as prices of exports, import prices remaining unchanged, the actual
gain from trade will not change.
Jevons, however, criticised terms of trade a an index of the gain from trade on
the ground that the total amount of gain from trade depends on total utility,
whereas terms of trade are related to marginal utility. It is, thus, ridiculous to
say that the total amount of gain can be obtained by multiplying the gain from
the marginal unit of trade by the total value of trade. Total gain from trade may
increase, even though terms of the trade may have decreased, if there is a
considerable increase in the volume of trade. In fact, the total gain from trade
is to be defined as the excess of the total utility derived from imports over the
total disutility of export.
Changes in Gains
Changes in gains may occur due to the following causes:
1. Changes in the terms of trade largely affect the gains when terms of
trade of a country become favourable; its proportion of sharing in gains
from trade becomes larger.
2. Changes in the cost of production of exports of a country affect its

gain. If due to technological advancement and other reasons, cost of
production is reduced, the exporting country will find in improvement
in its gain.
3. When the volume of trade of a country increases, its gains also
increase.
4. With changes in the composition of the pattern of trade a country’s
gains also change. If a country’s export changes such that commodities
with greater comparative cost advantage are replaced for goods with
lower comparative costs advantage, its gains improve.
5.1.3 GAINS FROM INTERNATIONAL TRADE
International trade is beneficial to all the participating countries. It enables a
country to export a commodity to other countries and thus secure a better
market for it. International trade enables a country to import a commodity which
it cannot produce at all or can produce only at a high cost. Thus, a trade and
exchange are good for the sellers and buyers; similarly international trade is
good for the trading countries. It is for this reason that Adam Smith and the
classical economists advocated more trade and freer trade between countries
so that the gain to all countries could be maximised.
i. Advantages of International specialisation
In the absence of trade, every country will be forced to produce all types of
goods which it requires but for which it may not have the necessary resources.
International trade will enable each country to specialise in the commodities in
which it has absolute or comparative cost advantages. That is, the country
which possesses plenty of land, such as Argentina or Australia, will produce
what and meat and export them. England which has advantage in capital
equipment and in skilled labour will produce and export machines and
manufacture articles but will import foodstuffs and raw materials. Similarly,
Japan which has very little of land but has an industrious population and plenty
of capital equipment will produce all types of manufactures but will import raw
materials in which it is deficient. It is thus clear that international trade is the
basis of international specialisation and the advantages associated with such
specialisation.
Specialisation leads to the best utilisation of the resources in a country,

concentration in the production of only those goods in which the country has a
comparative advantage, saving of time and perfection of skills in production
and improvement in the techniques of production. All these advantages which
flow from international specialisation result in increased production in all trading
countries. We can illustrate the gain to trading countries in the form of increased
production, with the help of the example of comparative advantage we have
given in Chapter one of this part.
10 days of labour can produce in India 100 units of cotton

or
100 units of wheat
10 days of labour can produce in Pakistan 50 units of cotton
or
80 units of wheat
For the sake of simplicity, let us assume that each country possesses 20
days of labour and that output can be added u. In the absence of trade, we
may state that each country produces both the goods, 10 days of labour
producing cotton and another 10 days of labour producing wheat. The total
output will be :
Cotton 100 Units in India

+ 50 Units in Pakistan
150 Units in the two countries
Wheat 100 Units in India
+ 80 Units in Pakistan
180 Units in the two countries
Total output 330 Units of cotton and wheat
Thus, the total production in the two countries adds up to 330 units of cotton
and wheat. Suppose that trade takes place between the two countries with
India specialising in cotton in which it has comparative advantage and Pakistan
specialising in wheat in which it has comparative advantage.
Cotton 200 Units in India

Wheat 160 Units in Pakistan
Total 360 Units of cotton and wheat
It is, thus, clear that international trade will lead to international specialisation,
which, in turn, will lead to increased production and, therefore, higher standards
of living in the trading countries. We have assumed the law of constant returns
in the above example. In practice, however, the law of diminishing returns
applies of production. This will naturally reduce the scope for international
specialisation but will not remove it altogether.
ii. Equalisation of prices between countries
A commodity is cheap or costly depending upon its supply and demand. For
Instance, a commodity will be cheap in a country where it is produced with an
abundant supply of some essential factors. It will be expensive in that country
where there is a scarcity of necessary resources. In the absence of trade, the
commodity in question will have two sets of prices, a low price in the first
country and a high price in the second country. Through trade, the supply of
the commodity is reduced in the country where it is produced with abundant
factor supply; and, thus, its price is raised there. Its supply is increased in the
importing country and thus its price is reduced there. In this way, the difference
being, of course, the cost of transportation.
There is another interesting point too. Through equality of prices of goods,

international trade helps to equalise the prices of the factors of production also.
Abundant factors will get higher prices, since the commodity produced with
their co-operation gets higher prices. Thus will be so in all countries. But complete
equalisation of factor prices is not possible in practice. Besides, as and when
factor pries are equal, there will be no difference in the costs of production and,
therefore, there will be no tendency for trade itself to take place.
iii. Equitable distribution of scarce Materials
There is no country in the world - including such industrial giants as the U.S.A.
and the U.S.S.R. - which has all the resources to produce all the goods it
requires. At the same time, there are some countries like Indonesia, Malaysia
and Congo in Africa which have been blessed by nature with some rare minerals
like tin, copper, etc. International trade is the only method by which a country
can supplement its shortage of resources. Further, it ensures equal access
to scarce raw materials for all countries of the world.
It is necessary to emphasise the close causal relation between international

trade and modern industrial economies. Modern industrial production is based
on extensive specialisation and large-scale production. Both are based on the
existence of large markets. The larger and more extensive the market for the
products, the greater is the degree of specialisation and large-scale production.
In the nineteenth century, England was able to industrialise its economy
because it could find ready markets for its machinery and manufactures in
European countries and in its colonies. Later, Germany, the U.S.A. and Japan
followed in the footsteps of England. It is through international trade that the
markets for products have been expanded to cover the entire world. The
modern industrial economy could not have evolved in the absence of
international trade and of all the factors which have helped the expansion of
international trade (We mean here transportation and international finance).
The gains from international trade can broadly be classified into two categories
- gains from specialisation and gains from exchange. The gains from
specialisation consist of the best utilisation of resources, and concentration in
the production of those goods for which the country has the best factor
endowments. Gains from exchange imply better prices - a relatively higher
price for the exporting country but relatively lower price for the importing country.
The productive factors in the exporting country get a better price and better
remuneration, while the consumers in the importing country secure the
advantages from lower prices. Producers enjoy higher prices due to more
specialised use of the country’s abundant resources and consumers enjoy a
higher level of satisfaction due to more favourable terms of exchange.
CHECK YOUR PROGRESS
1. The achievement of gains from trade requires comparative cost

advantage.
2. Distribution of gains from trade is thus measured in terms of
(i) Terms of Trade (ii) Domestic cost ratios.
SUMMARY
The tremendous expansion of international trade is in itself the best proof that
nations gain from trade. International trade leads to the division of labour or
specialisation on a larger scale. International trade enlarges the market and,

therefore, the scope of division of labour. International trade, thus, increases
the gain from the division of labour. The gains from International trade
encourage the development of the most efficient sources of supply. International
trade enables specialisation. On a large scale because of the expanded market
which enables the realisation of economies of scale. The gains from trade
may not be evenly distributed between the participants some countries may
gain more whereas other gain may be relatively less. The most important
determinant of the distribution of gain is the terms of trade i.e. the rate at
which a country’s export are exchanged for imports.
GLOSSARY
Gains from specialisation : The gains from specialisation consist of the best
utilisation of resources and concentration in the production of those goods for
which the country has the best factor endowments.
Gain from exchange : Imply better prices a relatively higher price for the
exporting country but relatively lower price for the importing country.
MODEL QUESTIONS
1. Explain the gains from trade.

2. Describe the measurements of gains from trade.
3. Explain the concept distribution of gains from trade.
BOOKS FOR REFERENCE

BLOCK - II
TERMS OF TRADE AND COMMERCIAL POLICY
Unit 6 : Trade policy
Unit 7 : Quota and Tariff

Unit 8 : Terms of Trade
74 Trade policy
UNIT 6
TRADE POLICY
STRUCTURE
Overview
Learning Objectives
6.1 Trade Policy
6.1.1 Meaning of Trade Policy
6.1.2 Meaning of Free Trade Policy
61.3 Case of Free Trade
6.1.4 Case against of Free Trade
6.1.5 Meaning of Protection
6.1.6 Case for Protection
Summary
Glossary
Model Questions
Books for Reference
OVERVIEW
In this unit, you are going to learn the meaning of Trade policy. It further explains
the meaning of free trade. It also further explains the advantages of free trade.
It emphasises the importance of protection. Pr the disadvantages of protection
is explained in this chapter.
LEARNING OBJECTIVES
Ø explain the meaning of protection

Ø explain the meaning of free trade
Ø summarise the advantages of Free trade
Ø describe the disadvantages of Free trade
Ø explain the meaning of protection
Ø explain the advantage of protection
6.1 TRADE POLICY
6.1.1 MEANING OF TRADE POLICY

Trade policy refers to measures which a country adopts for the purpose of
regulating the exchange of goods with other countries in the context of economic
development.
6.1.2 MEANING OF FREE TRADE POLICY

Policy of non-interference by government in foreign trade is referred to as
“free trade”.
6.1.3 CASE OF FREE TRADE

The following arguments have been advanced in favour of free trade policy.
1. Comparative cost advantage
Free trade is the natural outcome of the comparative costs advantage. It permits
an allocation of resources, and manpower in accordance with the principle of
comparative advantage, which is just an extension of the principle of division
of labour.
“The fact of free trade establishes an overwhelming presumption that the
commodities obtained from abroad in exchange for export are so obtained at
lower cost than which the domestic production of their equivalents would entail.
If this were not the case, they would not imported, even under free trade”,
says Jacob Viner.
It has been maintained that the gain from free international trade would be the
largest due to international specification based on comparative advantage.
Free trade leads to the most efficient conduct of economic affairs. In a plea for
free trade, they also said that even if some countries do not follow the policy of
free trade, an industrial country should follow it unilaterally and it will gain thereby.
2. More factor earnings
Under free trade, factors of production will also be able to earn more, as they
will be employed for better use. Hence, wages, interest and rent will be higher
under free trade than otherwise.
3. Cheaper imports
Free trade procures import at cheap rates. It seems to be an attractive
argument in favour of trade at least from the customer’s point of view. However,
76 Trade policy
it ignores the question of employment and the interests of producers in the

importing country. Here it has been pointed out that under free trade, when
consumers gain through lower prices; producers also gain as the factors of
production are directed to more gainful and specialized production which gives
better earnings.
4. Enlarged market
Free trade widens the size of the market as a result of which greater
specialization and a more complex division of labour become possible. This
brings about optimum production with costs reduced everywhere, benefiting
the world as a whole.
5. Competition
Free trade policy encourages competition from abroad which induces domestic
producers to become more alert and improve their efficiency.
6. Restricted exploitation
Free trade prevents growth of domestic monopolies and consumers’

exploitation due to competition from abroad.
7. Greater Welfare
Free trade permits large varieties of consumption goods and improves

consumer’s welfare.
Heberler concludes that, “international trade has made a tremendous

contribution to the development of less developed countries in the nineteenth
and twentieth centuries and can be expected to make in the future if it is allowed
to proceed freely”. Thus, free trade is the best commercial policy.
6.1.4 CASE AGAINST OF FREE TRADE

However, the following disadvantages of free trade policy have been mentioned
by many critics.
1. Free trade policy runs smoothly if all the countries follow the same. If
some countries do not adopt it, the system cannot work gainfully.
2. Free trade may prove advantageous to developed and technologically
advanced nations, but less developed countries are certainly at a
disadvantage on account of unfavourable terms of trade.
3. Competition induced under free trade is unfair and unhealthy. Backward

countries cannot compete with advanced countries.
4. Gains of trade are not equally distributed under free trade due to unequal
state of development of different countries.
5. A country with unfavourable balance of payments finds it difficult to
overcome this situation under free trade policy.
6. Free trade may encourage interdependence and discourage self-
sufficiency. But, in the matter of defence each country should have
self-reliance and self-sufficiency as far as possible.
6.1.5 MEANING OF PROTECTION
Protection is the policy of encouraging home industries by paying bounties (or
giving subsidies) to domestic producers or more usually by imposing customs
duties on foreign products.
When a country resorts to protection as a commercial policy, can adopt many

alternative devices or their combinations. The important method of protection
are: (1) Tariffs, (2) Quotas, (3) Exchange control, (4) State trading, (5) Dumping,
(6) Subsidies, (7) Commodity agreement and (8) International cartels.
6.1.6 CASE FOR PROTECTION
The main arguments in favour of protection are;
“Infant Industry” Argument
It is held that infant industries during the early stages of their development
require protection from competition from foreign exporters. An infant industry
is one which has been started rather late or newly, and which has not been
mature enough to face competition from long – established foreign industries.
Such an industry, in the initial stages of its growth, needs full protection from
the state without which it cannot survive. For an infant industry, operating costs
during the transition period are high. As such, it cannot compete with
established foreign exporters. This is particularly true of a country that is
attempting to initiate industrialization. By imposing a tariff on imports, the
domestic price is, therefore, raised sufficiently to allow the high costs of
domestic producers to maintain themselves.
However, the exponents of the infant industry argument emphasized that
protection should be temporary and should be removed immediately after it
78 Trade policy
has performed its function of “nursing”. Evidently, the infant industry argument
is not against free trade. It advocates protection temporarily only in the initial
stages, so that all countries should develop themselves fully and the volume
of trade is maximized. Once the industry becomes mature enough, protection
should be withdrawn.
“Diversification of Industry” Argument
Protection is advocated by List and other economists to diversify the industries

of a country. When there is unbalanced economy as a result of excessive
specialization, excessive specialization leads to over-dependence of a country
on other countries. This is dangerous politically, as well economically. Politically
in times of war, imports from foreign countries become difficult and people
have to suffer hardships. Economically, there is danger of serious economic
dislocation in case adverse circumstances affect these few industries on which
the country is dependent. Thus, in order to bring about a harmonious and
balanced growth of all industries and self-sufficiency it is necessary to bring
about a diversification of industries through protection.
“Promotion of employment” Argument
It is believed that imposition of tariff leads to expansion of employment and

incomes. The belief was extremely popular in the thirties, the period of the
Great Depression, when cyclical unemployment was prevailing throughout
the world. Tariff was then regarded as a fairly practicable means of lessening
cyclical unemployment. Imposition of tariff restricts certain imports so that
some money is saved in the domestic economy which will be spent upon the
purchase of the products of protected home industries. As the protected
industries expand, employment therein increases and income of the economy
increases. This generation of income will have a multiplier effect. There will
be expansion of employment and income in other sectors of the economy as
well. The overall rise in output will require more capital. Hence, net investments
in capital goods industries will rise, which will stimulate further investment,
employment and income through “acceleration effect”. Hence, the final increase
in employment and income is greater than that initially generated by the
expansion of protected industries. Moreover, tariffs may even attract foreign
capital as producers abroad seeing their market threatened, may set up plants
within the country to prevent its passing to domestic producers. Therefore,
the existence of unemployment in an industry usually is considered a very

good reason for the imposition of a tariff.
“Balance of Payments” and “Terms of Trade” Arguments
For correcting disequilibrium in the balance of payments, tariff duty can be

used as an instrument for making the terms of trade more favourable to the
country. The terms of trade can be improved by making foreigners pay whole
or part of the tariffs. For, the imposition of tariff duty will lead to a rise in the
price of the importing country and a fall in the price of the exporting country
and if the demand for the commodity is elastic, then the price in the exporting
country will fall to a greater extent. Thus, the burden of tariff duty is borne by
the exporting (foreign) country. Hence, tariff duty moves to a more favourable
terms of trade for the importing country. This will, however, depend upon the
extent to which the price rises in the importing country and the extent to which
it will fall in the exporting country.
If tariff duty is imposed, the prices will rise in the importing country and fall in
the exporting country. If the demand for the commodity of the exporting country
is elastic, its prices will fall to a greater extent. If the demand for it is elastic, a
small rise in the price will lead to a greater fall in demand. If the supply of the
commodity is more elastic, the price will rise to a lesser extent. But if the
domestic supply is inelastic, then the price will rise to a larger extent.
“Pauper Labour” Argument
Protection is sometimes advocated, especially in the industrially advanced

countries, in order to safeguard the interests of labour. It is argued that in the
absence of protection, there will bean unhealthy competition faced by countries
having dear labour economy from those having cheap labour. The product of
high wage labour of these countries will be undersold by the “pauper labour”
countries. Thus, in the advanced countries where the people enjoy high real
wages, it is often felt that their standard of living will be undermined if cheap
goods are imported from low wage countries. Hence, to protect a country’s
high standard of living and maintain its high wages, tariffs become essential
to rule out competition from “pauper labour” countries.
80 Trade policy
“Anti - Dumping” Argument
Protection is also advocated as an anti-bumping measure. A foreign country

may resort to dumping with a view to capturing markets in another country.
Thus, a high tariff may be demanded in order to protect home producers against
dumping of foreign goods in the home market at a much lower price and than
what the foreign monopolist charges in their own country.
CHECK YOUR PROGRESS
1. Free trade means absence of restrictions of foreign trade.

2. The contents of trade policy are tariff, quotas and exchange restriction.
3. The protectionist trading policies of advanced nations hinder the
industrialization of many developing nations.
SUMMARY
Trade policy refers to measures which country adopts for the purpose of
regulating the exchange of goods with other countries in the contest economic
development. The contents of trade policy are Tariff, quotas and exchange
restrictions. Free trade is a policy where no tariffs and quantitative restrictions
and other devices obstructing the flow of goods between nationals are imposed.
The advantages of free trade are comparative cost advantage more factors
earnings, cheaper imports, enlarged market competition, restricted exploitation
greater welfare.
GLOSSARY
Protection : A commercial policy directed to protect home industries from

foreign competition.
Free Trade : An international trade policy which does not impose any tariff or
non-tariff restrictions upon free exchange of foods and services between the
trading countries.

MODEL QUESTIONS
1. Bring out the merits and demerits of Free trade?

2. Put forth the arguments for protection.
3. Describe the trade problems of developing countries.
BOOKS FOR REFERENCE

3. D.M. Mithani - International Economics
4. Francis Cheruneelam - International Economics
82 Quota and Tariff
UNIT 7
QUOTA AND TARIFF
STRUCTURE
Overview
Learning Objectives
7.1 Quota - Tariff
7.1.1 Meaning of Quota
7.1.2 Types of Quota
7.1.3 Meaning of Tariff
7.1.4 Types of Tariffs
7.1.5 Dumping
7.1.6 Anti-dumping measures
Summary
Glossary
Model Questions
Books for reference
OVERVIEW
In this unit, you are going to learn the meaning of quota and the types of quota.
It further explains the meaning of Tariff. It emphasis the importance of
antidumping measures.
LEARNING OBJECTIVES
Ø explain the meaning of Quota

Ø list out the types of quota
Ø summarise the antidumping measures
7.1 QUOTA - TARIFF
7.1.1 MEANING OF QUOTA

Quota is a protectionist device of restrict the supply of a good or service from
abroad.
7.1.2 TYPES OF QUOTA

i. Tariff Quota : Under this quota system a given quantity of a good is
permitted to enter duty free or upon payment of relatively low duty.
ii. Unilateral Quota : Under this system of quota, the total volume or
value of the commodity to be imported is fixed by law or decree without
any agreement with the other countries.
iii. Bilateral Quota : Under this quota system, quotas are fixed by some
agreement with one or more other countries.
iv. Mixing Quota : This system requires domestic producers in the quota
fixing country to use imported raw materials in certain proportion along
with domestic raw materials to produce finished products.
v. Import licensing: Import licensing is the system devised to administer
the various types of quotas.
7.1.3 MEANING OF TARIFF
A tariff is a tax or duty levied on product when it crosses national boundaries. The
most common tariff which is a tax levied on an imported product. A less common
tariff is an export tariff, which is a tax imposed on an exported product. Export
tariffs have been used by the Organisation of Petroleum Exporting countries in
order to raise revenue or promote scarcity in global market.
Tariffs may be imposed for protection. A protective tariff is levied in order to protect
import-competing industries from foreign competition. An import tariff on foreign
products puts the foreign industry at a disadvantage in the home market.
7.1.4 TYPES OF TARIFFS

Tariffs are classified in a number of ways as shown below:
I. Based on Purpose
1. Revenue Tarrif
2. Protective Tarrif
II. Based on Origin
1. Advalorem Duty
2. Specific Duty
3. Compound Duty
4. Sliding Scale Duty
84 Quota and Tariff
III. Based on Discrimination

1. Single Column Tariff
2. Double Column Tariffs
1. General and Conventional Tariffs
2. Maximum and Minimum Tariffs
3. Multiple or Triple Column Tariffs
IV. Based on Retaliation
1. Retaliatory Tariffs
2. Countervailing Duty
I. BASED ON PURPOSE
Based on the purpose for which tariffs are imposed, tariffs can be classified
into two such as: 1. Revenue, and 2. Protection.
(a). Revenue Tariff: Revenue tariffs are those, the primary purpose of which
is to provide the state with revenue. They constitute a special form of taxation.
Generally, if this is the main purpose of tariffs the rate of tariffs will be low and
particularly in case of articles of mass consumption they are the least.
(b). Protective Tariff: The main objective of protective tariff is not to create a
new source of income for the state but to maintain and encourage those
branches of home industry protected by the duties. Thus protective tariffs are
imposed with an intention to protect domestic industries from foreign
competition. Generally, in this case, the rates are high because only high
rates of duty curtail imports considerably. Now-a-days Governments levy import
tariffs with the primary objective of discouraging imports so that domestic
production may be encouraged. Here the revenue aspect of an import duty is
only secondary.
II. BASED ON ORIGIN
Based on the origin and destination, tariff duties are divided into four types
such as: 1. Advalorem 2. Specific, 3. Compound, and 4. Sliding scale.
(1). Advalorem Duty: Advalorem duty is the most common type of duty. It is
expressed as a fixed percentage of the value of the traded commodity. Say
10% or 20%. They are levied at a fixed percentage of the value of the commodity
imported. If import prices rise, advalorem duties shall also rise and if the
prices fall, the duties shall also tend to fall.
(b). Specific Duty: They are levies of fixed sums of money on each unit of
quantity imported. Thus a duty levied as a fixed amount of rupees per pound,
gallon, kilogram or other unit is called specific duty. The price of the commodity
is not considered here. For e.g. Rs. 1,000 per set of Television.
(c). Compound Duty: Compound duty is the combination of an advalorem

and a specific tariff. In this type of tariff, units of an imported commodity are
levied a percentage of advalorem duty plus a specific duty on each unit of the
commodity. For example, a country may impose an import duty on T.V. at the
fixed rate of Rs.1,000 + 5% on the price of the T.V.
(d). Sliding Scale Duty: Sliding scale duty is one where the duty varies with
the prices of commodities traded. It may either be an advalorem or a specific
duty. However, generally, sliding scale duties are levied on specific basis only.
III. BASED ON DISCRIMINATION
On the basis of country-wise discrimination, the following tariffs are levied.
(a). Single Column Tariff: Single column tariff is also known as uni-linear
tariff. Under it, duty is levied at the uniform rate for all like commodities
irrespective of the nations from which they are imported. It is a non-
discriminatory tariff. Its administration will be easy. But it is not adequate and
flexible.
(b). Double – Column Tariffs: Under double column tariffs, two different
rates of duty are levied for all or some of the commodities. Thus, under double
column tariffs, rates are discriminated between countries. This can be
classified further into two namely.
1. General and Conventional tariffs, and

2. Maximum and Minimum Tariffs.
(i). General and Conventional Tariffs: The general and conventional tariff
system consists of two schedules of tariffs namely, the general and the
conventional. The general tariff is the list of tariffs announced by the Government
as its annual tariff policy in the beginning of the year. It is the specific tariff
rate, which is charged from all countries. On the other hand, conventional
86 Quota and Tariff
tariff rates are based on trade agreements with other countries. These rates
may be different for different countries and even vary from commodity to
commodity. These rates are also not flexible and so they hinder the expansion
of foreign trade.
(ii). Maximum and Minimum Tariffs: The maximum and minimum tariffs
system consists of two autonomously determined schedules of tariff namely,
maximum rate and the minimum rate. The minimum rate is levied for those
countries with which it has a commercial agreement whereas for the rest of
the countries maximum tariff rate is imposed.
(c). Multiple or Triple Column Tariffs: Under the multiple column tariffs
system, two or more tariff rates are levied on each category of commodity.
But in practice, usually three different rates are levied namely, general,
intermediate and preferential. That is why this system is also called as Triple
Column Tariffs. The general rates are imposed in the same manner as
maximum rates explained above. The intermediate rates are the minimum
rates. The preferential rates are levied on goods imported from Britain before
Independence at present, imports between SAARC Countries carry preferential
rates of tariff on imports from one another.
IV. BASED ON RETALIATION
On the basis of retaliation, the tariffs are classified into two namely,
1. Retailatory Tariffs,
2. Countervalling Tariffs.
(a). Retaliatory Tariffs: A retaliatory tariff is imposed by one country on the
imports of another country so as to punish the latter for its trade policy, which
spoils its exports or balance of payments position.
(b). Countervailing Tariffs: Countervailing tariff duties are levied on a

commodity whose export is reduced by the other country through an export
subsidy. This is an additional duty levied with an idea to raise its price in order
to protect producers of the same commodity in the importing country from the
cheap foreign commodity.
7.1.5 DUMPING
Dumping is an international price discrimination in which an exporter firm sells
a portion of its output in a foreign market at a very low price and the remaining
output at a high price in the home market. Haberler defines dumping as : “The
sale of goods abroad at a price which is lower than the selling price of the
same goods at the same time and in the same circumstances at home, taking
account of differences in transport costs”.
7.1.6 ANTI-DUMPING MEASURES

The following measures are adopted to stop dumping :
1. Tariff Duty
To stop dumping, the importing country imposes tariff on the dumped

commodity. Consequently, the price of the importing commodity increases
and the fear of dumping ends. But it is necessary that the rate of duty on
imports should be equal to the difference between the domestic price of the
commodity and the price of the dumped commodity. Generally, the tariff duty
is imposed more than this difference to end dumping, but it is likely to have
harmful effects on other imports.
2. Import Quota
Import Quota is another measure to stop dumping under which a commodity

of a specific volume or value is allowed to be imported into the country. For
this purpose, it includes the imposition of a duty along with fixing quota, and
providing a limited amount of foreign exchange to the importers.
3. Import Embargo
Import embargo is an important retaliatory measure against dumping.

According to this, the imports of certain or all types of goods form dumping
country are banned.
4. Voluntary Export Restraint
To restrict dumping, developed countries enter into bilateral agreements with

other countries from which they fear dumping of commodities. These
agreements ban the export of specified commodities so that the exporting
country may not dump its commodities in other country. Such bilateral VER
agreements exist between India and EEC countries in exporting Indian textiles.
Conclusion
It is generally observed that anti-dumping measures explained above harm

rather than benefit the country adopting these measures. The producers of
88 Quota and Tariff
the country never want that commodities should be imported from abroad.
They, therefore, pressurise the government to restrict the import of better and
cheap imports by calling them duped commodities. The reason for this is to
misinterpret dumping. According to Article IV of GATT 1984, which now forms
part of the World Trade Organisation (WTO), a country can adopt anti-dumping
measures only if the dumped imports “injure” the industry of the country. A
commodity is regarded as dumped which is exported to the other country at a
value lower than its normal value. Or it will also be regarded as dumped if the
export price of the commodity is less than its comparable price for final
consumption in the exporting country. Under these situations, the importing
country can impose anti-dumping duty, provided the margin of dumping is
more than 2% of the export price or is more than 7% of the dumped import.
CHECK YOUR PROGRESS
1. Quota is an imposed limit on the quantity of goods produced or

purchased.
2. Bilateral quotas are fixed by some agreements with one or more other
countries.
3. To stop dumping, the importing country imposes tariff on the dumped
commodity.
4. An import tariff is a duty on the imported commodity, while an export
tariff is a duty on the exported commodity.
SUMMARY
The most important type of trade restriction has been the tariff. Developing
nation rely heavily on export tariffs to raise revenues. On the other hand,
industrial countries invariably impose tariffs. Import quotas are tariff quota,
unilateral quota, global quota System, tariff duty, import quota, import embargo,
voluntary export restraints are the measures adopted to stop dumping.
GLOSSARY
Dumping : The sales of a good in a foreign market at a price lower than that
charged for the same good in a domestic market.
Quota : An imposed limit on the quantity of goods produced or purchased.

1. True 2.True 3.True 4.True
MODEL QUESTIONS
1. Explain the types of quota.

2. What is meant by quota?
3. Describe the antidumping measures.
4. What is dumping?
5. What is tariff?
BOOKS FOR REFERENCE

4. Francis Cheruneelam - International Economics
90 Terms of Trade
UNIT 8
TERMS OF TRADE
STRUCTURE
Overview
Learning Objectives
8.1 Terms of Trade
8.1.1 Meaning of Terms of Trade
8.1.2 Types of Terms of Trade
8.1.3 Factors affecting terms of trade
8.1.4 Terms of trade and Economic development
Summary
Glossary
Model Questions
Books for Reference
OVERVIEW
In this unit you are going to learn the meaning of terms of trade and the types
of terms of trade. It further also explains the factors influencing terms of trade.
LEARNING OBJECTIVES
Ø explain the meaning of terms of trade

Ø describe the types of terms of trade
Ø discuss the factors affecting terms of trade
8.1 TERMS OF TRADE
8.1.1 MEANING OF TERMS OF TRADE

Terms of trade are an important measure to evaluate gains to individual
countries from international trade.
8.1.2 TYPES OF TERMS OF TRADE

Gerals M.Meier has classified the different concepts of terms of trade into the
following three categories:
1. Those that relate to the ratio of exchange between commodities:

(a) net barter terms of trade
(b) gross barter terms of trade, and
(c) income terms of trade
2. Those that relate to the interchange between productive resources:
(a) single factoral terms of trade, and
(b) double factoral terms of trade
3. Those that interpret the gains from trade in terms of utility analysis.
(a) real cost terms of trade, and
(b) utility terms of trade.
Net Barter Terms of Trade
Net barter terms of trade, also called the commodity terms of trade, measure
the relative changes in the import and export prices and is expressed as,
Px
N=
Pm
Where Px and Pm are price index numbers of exports and imports, relatively.
Gross Barter Terms of Trade
Taussig introduced the concept of gross barter terms of trade to correct the
commodity or net barter terms of trade for unilateral transactions, or exports
or imports which are surrendered without compensation or received without
counter payment, such as tributes and immigrant’s remittances.
The gross barter terms of trade are the ratio of the physical quantity of imports
to physical quantity of exports. It may be expressed as,
Qm
G =
Qx
where Qm and Qx are the volume index numbers of imports and exports
respectively.
92 Terms of Trade
Income Terms of Trade
G.S. Dorrance has modified that net barter terms of trade and presented the
income terms of trade. The income terms of trade, which indicates a nation’s
capacity to import is represented as,
Px − Qx
I =
Pm
Single and Double Factoral Terms of Trade
Jacob Viner has introduced the concepts of single factoral and double factoral
terms of trade to modify the net barter terms of trade so as to reflect changes
in productivity.
The single factoral terms of trade is the net barter terms of trade adjusted for
changes in the efficiency or productivity of a country’s factors in its export
industries. It may be expressed as,
S = N . Zx
where Zx is the export productivity index.
A rise in S implies that a greater quantity of imports can be obtained per unit of
factor-input used in the production of exportables. Hence, a rise in N is regarded
as favourable movements.
The double factoral terms of trade is the net barter terms of trade corrected
for changes in the productivity in producing imports as well as exports. It may
be expressed as,
D = N . Zx/Zm
where Zm is an import productivity index.
Real Cost Terms of Trade
The concept of real cost terms of trade, introduced by Jacob Viner, attempts
to measure the gain from international trade in utility terms.
To find out the real cost terms of trade, we correct the single factoral terms of
trade index by multiplying S by the reciprocal of an index of the amount of
disutility per unit of productive resources used in producing exports. The real
cost terms of trade may be represented as,
R = N. Fx . Rx
where Fx = index of productivity efficiency in export industries and
Rx = index of the amount of disutility incurred per unit of productive factors in

the export sector.
Utility Terms of Trade
The concept of utility terms of trade which was also introduced by Jacob Viner,
marks an improvement of the real cost terms of trade.
The utility terms of trade may be represented as,
U = N . Fx . Rx . Um
where Um = index of relative utility of imports compared to the commodities

that could have been produced for internal consumption with those productive
factors which are at present devoted to the production of export goods.
Effect of growth on Terms of Trade
To analyse the effect of growth on the terms of trade of a country, the following
assumptions are made:
1. Only the domestic country experiences growth

2. The factor which leads to growth is not taken into account.
3. International terms of trade are constant
4. Commodity terms of trade are taken.
Given the above assumptions, it is the growing country’s demand for imports
at constant terms of trade that determines its terms of trade. When the
demand for imports increases, the terms of trade of the growing country
deteriorate (or are unfavourable). In case the demand for imports decreases
after growth, its terms of trade improve (or become favourable). If the demand
for imports remains unchanged in the post-growth situation, its terms of trade
remains unchanged (or are neutral). These three possibilities are illustrated in
Fig.8.1 (A), (B) and (C). In Panel (A), BA is the domestic production possibility
curve. Growth is show in by its outward shift to B1A1. In the pre-growth situation
TT is the TOT (terms of trade) line which is tangent to the BA curve at point P
and the CI (community indifference) curve at point C. As a result of growth,
the production point shifts from P to P1 on the B1A-1 curve and the consumption
point from C to C1 on the CI1 curve which are points of tangency with the
94 Terms of Trade
constant terms of trade line T1T1 parallel to TT. In Panel (A), PP1 is parallel to
CC1 which means that the terms of trade of the growing country are constant.
This is because with the increase in the general expansion of output of X and
Y commodities, the share of domestic exportables is of the same degree as
the share in the general expansion of consumptions.
Fig.8.1 Effect of growth on Terms of Trade
If the consumption point C moves downwards to the right to C2 in the post-

growth situation on the B1A1 curve and the production points P and P2* as
shown in Panel (B), the terms of trade move in favour of the growing country.
This is because the output of the exportable commodity X increases more
than the domestic demand for it and exports increase more than the domestic
demand for the importable commodity Y.
If, on the other hand, the consumption point C moves to C3 and the production
point P to P3 on the B1A1 curve, in the post-growth situation, as shown in
Panel (C), the terms of trade will move against the growing country. This is
because the output o the exportable commodity X expands by less than the
domestic demand for it and the demand for the importable commodity Y rises
more than the exportable X.
Effects of growth on production, trade, welfare and terms of trade of a

small country
To analyse the effects of growth on trade and welfare of a small country, we

assume that (1) only one factor labour grows; (2) there are two commodities
X and Y; (3) growth of labour increases the production of labour-intensive
commodity X and decreases the production of capital-intensive commodity
Y; and (4) the international terms of trade remain constant for this country.
In the pre-growth situation in Fig.8.2 the production possibility curve is BA and

P is the production point where the terms of trade line TT is tangent to it. C is
the consumption point on the CI curve. CRP is the trade triangle whereby the
country exports RP of X and imports RC of Y commodity. After the growth of
labour, the production possibility curve shifts outward to B1A1. Note that the
shift along the horizontal axis AA1 is greater than BB1 on the vertical axis
representing capital even if there has been no increase in the growth of capital.
This is because labour is also used in the production of Y commodity. The
new production point is P1 and the consumption point is C1 where the constant
T1T1 line is tangential. Point P1 shows higher output of both X and Y
commodities. The volume of trade also increases after labour growth at point
P1 because the new trade triangle C1R1P1 is bigger than the pre-growth triangle
CRP. Country’s exports increase from RP to R1P1 and imports from RC to
R1C1. The welfare of the country also increases because the new consumption
point C1 is on the higher curve CI1 than the original point C on the CI curve.
However, when there is labour growth in the country without capital growth the
per capita availability of capital decreases. As a result, less capital is available
per labour which reduces the per capita productivity o capital. Therefore, the
availability of commodities per person in the country is reduced which is likely
to reduce the welfare of the commodity despite increase in the volume of
output and trade.
Fig.8.2 The production possibility curve
As the growth country is small, it trades of constant international terms of

trade even after growth because it is not in a position to influence international
96 Terms of Trade
terms of trade. The straight lien OT in Fig.8.3 shows constant terms of trade
where the pre-growth trade point is P and the post-growth point is P1 in country
A. Even at constant terms of trade, the country exports and imports more
quantities of X and Y commodities after growth, as point P1 is above P on the
OT line.
Fig.8.3 Constant terms of growth curve
8.1.3 FACTORS AFFECTING TERMS OF TRADE

Terms of trade are affected by a host of factors such as :
(i). Elasticity of demand for exports and imports : The nature of demand
elasticity is a very significant factor determining the terms of trade. If a country’s
demand for exports are compared to its demand for imports is more elastic,
terms of trade will tend to be favourable. If demand for imports is relatively
more elastic than its demand for exports, terms of trade will be unfavourable
for that country.
(ii). Nature of supply : If elasticity of supply of export is greater than that of
imports, terms of trade will be favourable.
(iii). Nature of production: If the country is producing only primary products
for exports and has to import manufactured goods in exchange, the terms of
trade will be unfavourable.
(iv). Size of country : If the country is well advanced and economically large
in size, it will have unfavourable terms of trade than in the case of a small
country. This is because a small country can reap the advantage of economies
of scale of the big country in international trade.
(v). Size of population : An overpopulated country will have a pressing demand
for good and relatively larger imports, so the terms of trade will tend to be adverse
in its case than in an under populated or optimally populated country.
6. Rate of exchange: If a country has increased the value of its currency in

terms of foreign currencies, terms of trade will tend to be in its favour.
7. Trade Policy: If a country erects a tariff wall and follows a restricted trade
policy, it can improve its terms of trade by restricting its imports.
8.1.4 TERMS OF TRADE AND ECONOMIC DEVELOPMENT

Economic development uplifts the production possibility frontiers of a country.
Economic growth, thus, implies an increase in the country’s gross product
(GNP). Per capita income also increases. As a result of change in income,
the income elasticity of demand for imports may change. The direction of
change in the terms of trade with economic development is determined by the
effect of growth on the net demand for imports. Rising income probably causes
an increase in the demand for goods for imports. Rising income probably
causes an increase in the demand for goods of import. But due to economic
growth, the domestic production (supply) of these otherwise importables may
also increase. The former effect of economic growth is described as income
elasticity of demand. It may be defined as the percentage change in the total
real income. The latter effect is called the income elasticity of supply which
may be defined as the percentage change in the production (supply) of
importables divided by the percentage change in the total real income. Both
these effects are to be measured at constant relative commodity prices. The
net effect of growth is the combined result of these supply and demand effects;
(1) When income elasticity of demand for the supply of importables is

equal to unity, their combined effect will cause an adverse change in
the terms of trade, because there will be a net rise in the demand for
importables.
(2) If the income elasticity of demand is greater than unity but that of supply
is less than unity, then also the terms of trade will change adversely
with economic development as there will be a net rise in the demand
for importables.
(3) When the income elasticity of demand is less than unity but that of
supply is greater than unity, the terms of trade will improve with growth,
because there will be a net fall in the demand for importable.
98 Terms of Trade
CHECK YOUR PROGRESS
1. Immigration is the factor which does not influence the terms of trade.
2. The terms of trade expresses the relationship between the export price
and the import price of a country.
3. The Gross Barter Terms of Trade is given by Taussig.
4. It elasticity of supply of export is greater than that of imports, terms of
trade will be favourable.
SUMMARY
Terms of trade expresses the relationship between the export price and import
price of a country. Terms of trade are favourable or unfavourable to a country.
When the export price is greater than the import price, terms of trade are
favourable to the country. If import prices are greater than the export price,
terms of trade unfavourable to the country.
GLOSSARY
Terms of Trade : A relationship between the process of exports and prices of

imports.
Factors Endowments : The levels of availability of factors of production in an

area or country.
MODEL QUESTIONS
1. What is terms of trade?

2. Explain the factors determining terms of trade.
3. What is factor endowments?
BOOKS FOR REFERENCE

BLOCK - III
BALANCE OF TRADE AND BALANCE OF PAYMENTS
Unit 9 : Balance of Payment
Unit 10 : Foreign Trade

100 Balance of payment
UNIT 9
BALANCE OF PAYMENT
STRUCTURE
Overview
Learning Objectives
9.1 Balance of Payment
9.1.1 Meaning of Balance of Payment
9.1.2 Components of Balance of Payment
9.1.3 Causes for Balance of Payment
9.1.4 Equilibrium and Disequilibrium in balance of payments
9.1.5 Measures to correct disequilibrium in BOP
Summary
Glossary
Model Questions
Books for Reference
OVERVIEW
In this unit, you are going to learn the meaning of BOP and components of
Balance of Payment. It explains the causes for disequilibrium in balance of
payment. It also further explains the equilibrium and disequilibrium in BOP
and measures to correct disequilibrium in Balance of payment.
LEARNING OBJECTIVES
Ø explain the meaning of Balance of Payment

Ø describe the components of Balance of Payment
Ø differentiate the equilibrium and disequilibrium in Balance of payments.
Ø explain the measures to correct the disequilibrium in Balance of
Payment
Ø discuss the causes for disequilibrium in BOP
9.1 BALANCE OF PAYMENT
9.1.1 MEANING OF BALANCE OF PAYMENT

The balance of payments, in an accounting sense, must always balance.
Debits must always equal credits if the entries are consistently made. It is
called as “equilibrium” in balance of payments. In other words, A country’s
balance of payments is in equilibrium when there is perfect equality between
the supply and the demand for foreign exchange.
9.1.2 COMPONENTS OF BALANCE OF PAYMENT

The balance of payments of country is a systematic record of all its economic
transactions with the outside world in a given year. It is a statistical record of the
character and dimensions of the country’s economic relationship with the rest
of the world. According to Bo Sodersten, “The balance of payments is merely a
way of listing receipts and payments in international transactions for a country”.
The balance of payments account of a country is constructed on the principle

of double-entry book-keeping. Each transaction is entered on the credit and
debit side of the balance sheet. But balance of payments accounting differs
from business accounting in one respect. In business accounting, debits (–)
are shown on the left side and credits (+) on the right side of the balance
sheet. But in balance of payments accounting, the practice is to show credits
on the left side and debits on the right side of the balance sheet.
When a payment is received from a foreign country, it is a credit transaction while

payment to a foreign country is a debit transaction. The principal items shown on
the credit side (+) are exports of goods and services, unrequited (or transfer)
receipts in the form of gifts, grants, etc. from foreigners, borrowings from abroad,
investments by foreigners in the country, and official sale of reserve assets including
gold to foreign countries and international agencies. The principal items on the
Debit side (–) include imports of goods and services, transfer (or unrequited)
payments to foreigners as gifts grants, etc., lending to foreign countries,
investments by residents to foreign countries, and official purchase of reserve
assets or gold from foreign countries and international agencies.
Table - 1
BALANCE OF PAYMENTS ACCOUNT
Credits (+) Debits (–)
(Receipts) (Payments)
1. Current Account
Exports a.Goods Imports a.Goods
b.Services b.Services
c.Transfer payments c.Transfer payments
2. Capital Account
a.Borrowings from Foreign a.Lending to Foreign
Countries Countries
b.Direct Investments by b.Direct Investments in
Foreign Countries Foreign Countries
3. Official Settlements Accounts
a.Increase in Foreign a.Increase in Official
Official Holding Reserve of Gold and
Foreign currencies
Errors and Omissions
9.1.3 CAUSES FOR BALANCE OF PAYMENT

Natural factors
Natural calamities, such as, the failure of rains or the coming of floods may
easily cause disequilibrium in the balance of payments by adversely affecting
agricultural and industrial production in the country. The exports may decline
while the imports may go up, causing a discrepancy in the country’s balance
of payment.
Social Factors
Certain social factors also influence balance of payments. For instance,

changes in the tastes, preferences and fashions, may affect imports and
exports and thereby affect the balance of payments.
Political Factors
The political factors may also produce serious disequilibrium in the country’s
balance of payments. For example, the existence of political instability may
result in disrupting the productive apparatus within the country, causing a
decline in exports and an increase in imports. Likewise, the payment of war

reparations or indemnities may also cause serious disequilibrium in the
country’s balance of payments. The imposition of heavy war reparations on
Germany after the First World War produced a serious disequilibrium in its
Economic Factors
The economic factors can be further subdivided under the following four
subheads :
(i) Cyclical Fluctuations
Business fluctuations induced by the operations of the trade cycle may also
cause disequilibrium in a country’s balance of payments. For example, if there
occurs a business recession in foreign countries it may easily cause a fall in
the exports and exchange earnings of the country concerned, resulting is a
disequilibrium in the balance of payments.
(ii) Inflationary spiral at Home
An inflationary rise in prices within the country may also produce disequilibrium
in the balance of payments. The prices of export items may go up, causing a
decline in the volume of exports from the country concerned. The inflationary
spiral within the country may also result in an increase in the volume of imports.
(iii) Capital Movements
The capital movements if they happen to be on a large scale can also cause
disequilibrium in the balance of payments of a country. A massive inflow of
foreign capital into a country is followed by an unfavourable balance of
payments. A large outflow of capital, on the other hand, is accompanied by a
favourable balance of payments.
(iv) Miscellaneous factors
The discovery of new substitutes for exports; the development of alternative

sources of supply, etc., may also produce disequilibrium in the country’s balance
of payments. For example, the invention of synthetic rubber led to a serious
decline in the export of natural rubber from countries like Malaysia, Burma,
etc. during and after the Second World War.
9.1.4 EQUILIBRIUM AND DISEQUILIBRIUM IN BALANCE OF PAYMENTS

Balance of payments always balances means that the algebraic sum of the
net credit and debit balances of current account, capital account and official
settlements account must equal zero. Balance of payments is written as
B = Rf – Pf
where, B represents balance of payments,
Rf receipts from foreigners,
Pf payments made to foreigners.
When B = Rf – Pf = 0, the balance of payments is in equilibrium.
When Rf – Pf > 0, it implies receipts from foreigners exceed payments made

to foreigners and there is surplus in the balance of payments. On the other
hand, when Rf – Pf < 0 or Rf < Pf there is deficit in the balance of payments
as the payments made to foreigners exceed receipts from foreigners.
If net foreign lending and investment abroad are taken, a flexible exchange
rate creates an excess of exports over imports. The domestic currency
depreciates in terms of other currencies. The exports becomes cheaper
relatively to imports. It can be shown in equation form :
X + B = M + If
Where X represents exports, M imports, If foreign investment, B foreign

borrowing
or X – M = I-f – B
or (X – M) – (If – B) = 0
The equation shows the balance of payments in equilibrium.
9.1.5 MEASURES TO CORRECT DISEQUILIBRIUM IN BOP

Subsidies to Export Industries
The Government should give subsidies to the export industries within the
country to enable them to cut down their production costs and improve their
competitive position in the international market.
Reduction in Imports
It is essential to cut down imports in order to eliminate the deficit in the balance
of payments of the country. The imports can be reduced by adopting the
following measures :
1. Imposition of New Import Duties and the Enhancement of the Existing

Import Duties : This step will go a long way in making imported goods more
expensive within the country. Consequently, the demand for the imported goods
will automatically decline in course of time.
2. Import Quota system : The imports of the country can also be cut down
through the adoption of the import quota system. This system can be discussed
under the following subheads :
(i). Licence Quota System : Under its system, the importers have to secure
import licences from the Government and these licences are granted by the
government after taking an overall view of the import position of the country.
(ii). Unilateral quota system : Under this system, the country imposes two
types of restrictions on its imports.
a. Global Quota System : Under this, the Government fixes in advance

the global quota for every imported item. The country cannot import
more than the quota fixed by the government. But, to the extent of the
quota, the importers can import the commodity concerned from any
country.
b. Allocated Quota system : Under this system, the Government not
only fixes the global quota of the commodity concerned but also
decides in advance how much of the commodity is to be imported
from individual countries.
iii. Bilateral Quota System: Under this system, the Government fixes the
maximum quota of a commodity which is to be imported from abroad. Up to
the extent of this quota, the commodity can be imported at a concessional
import duty. If, however, the importers exceed the quota, they have to pay a
penal rate of import duty.
iv. Import Prohibitions: This is an extreme measure which is sometimes

adopted by the Government of a country to eliminate the disequilibrium in the
balance of payments. Under this, the Government prohibits altogether the import
of certain goods which are considered to be non-essential from the national
point of view. Developing countries trying to bring about speedy economic
development through planning often resort to this method to check the
consumption of imported luxury goods by the affluent sections of the community.
Monetary Measures
The following monetary measures are taken either singly or in combination by

the government to deal with the disequilibrium in the balance of payments.
(a) Currency Devaluation
Devaluation means a deliberate reduction of the value of the national currency

in terms of other currencies. A country with a fundamental disequilibrium in
the balance of payments may devalue its currency in order to stimulate its
exports and discourage imports to correct the disequilibrium.
Devaluation always encourages exports by cheapening them in foreign

countries. On the contrary, devaluation had the effect of discouraging imports
by making them more expensive with the country. For example, if the currency
of a country is devalued, then its purchasing power in foreign countries
automatically goes down. In other words, the imported goods become more
expensive than before. Hence, devaluation discourages imports into the
country. On the contrary, the purchasing power of the devaluation.
Consequently, the foreigners start importing more goods from that country.
This gives an incentive to the exports of the country.
In India the first devaluation was made in September 1949. Again the rupee
was devalued for the second time on 6th June, 1966. Just before the
devaluation of the rupee with effect from 6.61966, the exchange rate was $1
= Rs.4.76. The devaluation of the rupee by 36.5 percent changed the exchange
rate to $ 1 = Rs.7.50. Before the devaluation, the price of an imported
commodity which cost $1 abroad was Rs.4.76 (assuming costless free trade).
But after devaluation, the same commodity which cost $1 abroad, would cost
Rs.7.50 when imported. Thus, devaluation makes foreign goods costlier in
terms of the domestic currency and this discourages imports. ON the other
hand, devaluation makes exports (from the country that has devalued the
currency) cheaper in the foreign markets. For example, before devaluation, a
commodity which cost Rs.4.76 in India could be sold abroad at $1 (Assuming

costless free trade), but after devaluation, the landed cost abroad of the same
commodity was only $ 0.64.
1. Effects of Devaluation : The effects due to devaluation may be analysed

in the following manner.
(i) Effects of Devaluation on Exports
Whether the devaluation will increase, reduce or leave unaffected the export
earnings will depend upon the extent of the elasticity of demand for the country’s
exports. For the purpose of analysis, we will consider the following three
situations.
a. In the case of elasticity is greater than unity, devaluation will result in

an increase in the total export earnings if the price elasticity of demand
for its exports is greater than unity.
b. In the case of elasticity is less than unity, devaluation will result in a
decrease in the total export earning if the price elasticity of demand for
the exports it less than unity.
c. In the case of elasticity is equal to unity, a fall in the price by percent
will cause the demand to increase proportionately so that there will not
be any change in the total export earnings.
(ii) Effects of Devaluation on Imports
As pointed out in the beginning of this chapter, devaluation increases the price
of imports (in terms of the currency that is devalued). It must be remembered
that the price of imports rises in terms of the home currency and not in terms
of the foreign currency. Devaluation does not directly affect the supply price of
imports expressed in foreign currency. As devaluation increases the price of
imports in the terms of the home currency, there will be a fall in the volume of
imports if the price elasticity of demand for imports is greater than zero (em>0).
When the volume of imports falls, there will, obviously, be a proportionate
saving of the volume of imports and the corresponding savings of the foreign
exchange will depend upon the price elasticity of demand for imports.
2. Limitations of devaluation : The success of devaluation depends on the

fulfillment of certain conditions :
i. Devaluation is not likely to produce favourable effects if other countries

retaliate by also devaluing their currencies. Thus, the co-operation of
other countries is necessary to make devaluation a success.
ii. Devaluation will not succeed in increasing exports and decreasing
imports if the domestic prices rise by a rate equal to or higher than the
rate of devaluation. Sometimes, devaluation may lead to some rise in
domestic prices. For instance, if imported inputs are used even after
devaluation, the cost of the production of goods embodying imported
inputs will go up.
iii. The success of devaluation depends also on the price elasticities of
demand for exports and imports. The Marshall-Lerner condition says
that devaluation will improve the balance of payments only if the sum
of elasticities of demand for the country’s exports and of its demand
for imports is greater than one.
iv. Even though devaluation increases the demand for a country’s exports
considerably, there could be another constraint, namely, inadequacy
of exportable surplus.
(b) Monetary contraction
If the Government of a country does not look upon currency devaluation as a

proper measure, it may resort to currency contraction to remove the
disequilibirum in the balance of payment. The prices of goods and services
automatically go down as a result of currency contraction. This gives the much
needed incentive to exports. But the imports are discouraged as a result of
the fall in international price level. The increase in exports and the decline in
imports helps the country to remove the disequilibrium in the balance of
payments. But currency contraction as a method to remove the disequilibrium
in the balance of payments is not looked upon with favour by certain economics.
If the price level in the country is deliberately brought down with the help of
currency contraction, it may pose a serious economic problem for the country.
It may even lead to a slump in the economy. Hence the method of currency
contraction should be used with a good deal of caution to bring about an
improvement in the balance of payments.
(c) Exchange control
Sometimes, the Government prefers exchange control to other methods for

bringing about an equilibrium in the balance of payments. Under this system,
the exporters have to surrender their earnings of foreign exchange to the
Government in exchange for domestic currency. Likewise the Government
allocates foreign exchange to the importers to enable them to make payments
for imported goods. Thus, the Government comes to have full control over
foreign exchange. It utilises the exchange control system to effect a cut in the
volume of imports. Unnecessary imports are altogether stopped by the
Government by denying foreign exchange to the importers. Many developing
countries like India, Kenya, Sudan, Nigeria and others have been restricting
imports by not releasing foreign exchange for non-essential goods.
(d) Foreign loans
The Government can also secure loans from foreign banks or foreign
Governments to reduce the deficit in the balance of payments. Since the
payment of these loans is spread over a long period, this helps the Government
to remove the deficit in the balance of payments. During the currency of the
loans, the Government takes steps to improve its foreign exchange position.
(e) Encouragement of Foreign investment
The Government induces the foreigners to make investment in the country

offering them all sorts of incentives and concessions. This provides the
Government with extra foreign exchange which is utilised to reduce the deficit
in the balance of payments. But while inviting the foreign capitalists to invest
their capital within the country, the Government sees to it that this does not
produce any adverse repercussions on the economy.
(f) Incentives to Foreign Tourists
The Government may also encourage the foreign tourists to visit the country
in increasing numbers by offering them various facilities and concessional
travel. This increases the foreign exchange earnings of the country with the
help of which the deficit in the balance of payments can be reduced.
To sum up, the deficit in the balance of payments is not a desirable

phenomenon for a country. The methods discussed above aim at reducing
imports and stimulating exports. Of these, the first method, trade measures,
is obviously the best and the most effective. It produces immediate results.
The Government of a country may use this method in combination with other
methods to eliminate or reduce a chronic deficit in its balance of payments.
CHECK YOU PROGRESS
1. In Balance of payment accounts, capital accounts deals with payments

of debts and claims.
2. Balance of payment includes all international economic transactions.
3. The balance of payments account of a nation follows the procedure
known as double-entry book keeping.
4. Outflow of Gold should not be entered in the current account of the
Balance of Payments of a country.
SUMMARY
Balance of payment always balances means that the algebraic sum of the net
credit and debit balances of current account, capital account and official
settlements accounts must equal zero. Balance payments in written as
B = Rf - Pf
The Balance of payments on current account covers all the receipts on account
of earnings or opposed to borrowings and all the payments arising out of
spending as opposed to lending. The capital account in the balance of payments
includes short term as well as longterm international borrowing and lending.
When there is deficit or surplus in BOP of a country it is adjusted through the
automatic adjustment through price and income changes.
GLOSSARY
Balance of payment : A systematic annual record of a country’s imports and

exports of visible and invisible items with the rest of the world.
Current Account : That part of a balance of payments account which portrays

the market value of a country’s visibles and invisibles exports and imports
with the rest of the world during a year.
1. True 2. True 3. True 4. True.
MODEL QUESTIONS
1. Enumerate the principle items in the balance of payments of a country?

2. “Balance of payment always balances”. Elucidate.
3. Explain the measures to correct the disequilibrium in BOP?
4. Describe the components of BOP.
BOOKS FOR REFERENCE
1. M.L.Jhingan - Internal Economics

2. Francis Cherunilam - International Economics
3. D.M.Mithani - International Economics.
112 Foreign trade
UNIT 10
FOREIGN TRADE
STRUCTURE
Overview
Learning Objectives
10.1 Foreign Trade
10.1.1 Composition of India’s Foreign Trade
10.1.2 Direction of Indian Foreign trade
10.1.3 Multinationals in India
10.1.4 Recent Trends in Foreign Trade
Summary
Glossary
Model Questions
Books for reference
OVERVIEW
In this Unit, you are going to learn about the Direction of India’s Foreign Trade.
It focuses on composition of India’s Foreign Trade. It emphasis on multinationals
in India. It further emphasizes on recent trends in foreign trade.
LEARNING OBJECTIVES
Ø explain the compositions of India’s Foreign Trade.

Ø explain the role of multinationals in India
Ø describe the concept direction of India’s Foreign Trade
Ø state the recent trends in Foreign Trade
10.1 FOREIGN TRADE
10.1.1 COMPOSITION OF INDIA’S FOREIGN TRADE

The Directorate of General of Commercial Intelligence and Statistics (DGCI&S)
has revised the commodity classification of India’s foreign trade with reference
to 1987,-88, trade data before and after 1987-88 are not strictly comparable.
We have made an effort to adjust the data for the year 1970-71 and 1980-81
as per revised classification so that it provides some basis of comparison.
Pattern of Imports
Imports have been now classified into Bulk Import and Non-bulk Imports. Bulk
imports are further sub-divided into three components (i) Petroleum, crude
and products, (ii) Bulk consumption goods which comprise of cereals and
pulses, edible oils and sugar, (iii) other bulk items comprising of fertilizers,
non-ferrous metals, paper and paper boards, rubber, pulp and waste paper,
metallic ores, iron and steel.
Non-bulk imports are also further classified into three components (i) capital
goods which include metals, machine tools, electrical and non-electrical
machinery, transport equipment and project goods, (ii) Mainly export - related
items consist of pearls, precious and semi-precious stones, organic and
inorganic chemicals, textile, yarn and fabrics, cashew nuts, (iii) Others include
artificial resins and plastic materials, professional and scientific instruments,
coal and coke, chemicals - medicinal and pharmaceutical products, non-
metallic mineral manufactures etc.
A close perusal of table 10 reveals that there has been a persistently rising
trend of imports which is the result of both internal and external factors. During
the seventies, as a result of the sharp hike in oil prices by the Organisation of
Petroleum Exporting Countries (OPEC) first during 1973-74 and then again in
1979-80, the value of POL imports rose sharply not only during the seventies,
but its impact was felt even during the eighties as well. The economy also
suffered a major drought in 1979-80.
During the eighties, a number of factors produced a cumulative effect in

pushing up imports. Notable among them were a higher outflow of foreign
exchange consequent upon the bike in POL prices as a part of the legacy of
the preceding decade, severe shortages on account of the unprecedented
drought of 1987, the growing pressure of demand accompanied with the
stepping up of the real growth of the economy and the policy of liberalisation
adopted by the Government. All these factors set in motion a process which
led to relatively larger dependence of the economy on imports. Imports which
aggregated to Rs.1,634 crores in 1970-71 rose sharply to Rs.12,549 crores
in 1980-81, the annual growth rate was as high as 19.2 per cent during the
114 Foreign trade
decade. During the eighties and more especially after 1984-85 when Prime
Minister Rajiv Gandhi followed the policy of liberalisation, imports zoomed
forward to Rs.43,190 crores in 1990-91. During the eighties (1980-81 to 1990-
91), the annual rate of growth of imports was as high as 13.1 per cent. During
1990-91 and 2004-2005, imports grew at the annual rate of 18.8 per cent.
It is customary to blame the POL items for the rise in imports, while this was
largely true during the seventies, the experience of the eighties reveals that
the average annual growth of POL items was barely 7.4% during 1980-81 to
1990-91, but the overall growth of imports was of the order of 13.1 per cent
per annum. The explanation of a rapid increase in imports has, therefore, to
be sought in terms of the policy of liberalisation in the name of technological
upgradation pursued by the Congress (1) government. However, data provided
in table 9 shows that during 1996-97 and 2005-06, 0 year period, imports of
POL rose by in annual average of 17.8 per cent, while rise in non- POL items
was of the order of 14.2 per cent per annum.
Bulk imports which comprise basic raw materials, intermediates and foodstuffs
are linked to the growth and stability of the economy, grew at an annual average
growth rate of 23.2 per cent during the seventies. As a result, their share in
total imports went up from 50.5 per cent in 1970-71 to 69.6 per cent in 1980-
81. However, their rate of growth significantly declined during the eighties as
well as during the nineties and even thereafter.
Among the non-POL bulk items, consumption goods comprising cereals and
cereal preparations, edible oils pulses and sugar which was around 10.7 per
cent annum during 1980-81 to 1990-91, shot up to 20.8 per cent during 1990-
91 and 2000-01. This was due to a very sharp increase in the import of edible
oils, which increased from Rs.326 crores in 1990-91 to Rs.11,674 crores in
2003-04. However, the imports of iron and steel recorded a much higher growth
rate of 14.4 per cent per annum during 1985 - 86 to 1990-91, but declined
thereafter during 1991-2003.
By and large, the growth rate of bulk items decelerated during the Seventh
Plan to 7.2 per cent as against 10.2 per cent during the sixth Plan.
Consequently, the share of bulk items in total imports fell to 58.6 per cent in
1984-85 and further declined to 39 per cent in 1980-81 started picking up and
was of the order of about 21.1 per cent during 2004-05.
Consumer goods and foodgrains
The imports of consumer goods and foodgrains accounted for 40 per cent of
India’s imports during the First Plan period, showing the extent of India’s under
- development and her dependence on foreign countries even for a basic
necessity like foodgrains. But the imports of these have gradually declined
over the years - 35 per cent during Second and Third Plan period, 27 per cent
during the Fourth Plan and 24 per cent of total imports in 1990-91, but their
share increased to about 4 per cent during 2002-03. This was largely due to a
sharp increase in edible oil imports, although foodgrains (cereals and pulses)
imports became negligible 2000-01.
From 1957 towards, imports of foodgrains were considerable and these were
arranged through PL 480 Aid from USA. Till the beginning of the Fourth Plan,
India’s imports of foodgrains as a percentage of total imports was increasing.
Foodgrain imports increased because of the draught conditions and inability
of the domestic supplies to meet domestic demand fully. It was only during
the Fourth Plan that imports of foodgrains declined to 10 per cent. In fact, with
the accumulation of large reserves of foodgrains, their imports were virtually
eliminated in certain years during 1970’s and they are minimal in 1990’s. Thus,
the structural changes in imports since 1951 show :
(a) rapid growth of industrialisation necessitating increasing imports of

capital goods and raw materials.
(b) growing imports of raw materials on the basis of liberalisation of imports
for export promotion; and
(c) declining imports of foodgrains and consumer goods due to the country
becoming self-sufficient in foodgrains and other consumer goods
through agricultural and industrial growth.
Trade of Principal Imports
Foodgrains
The imports of foodgrains were necessitated by the partition of the country

and the growing demand for food for the rising population. The average annual
imports of foodgrains which were about Rs.120 crores during the First Plan,
rose to Rs.161 crores during the Second Plan, further increased to an average
rate of Rs.241 crores during the Third Plan. The drought of 1965-66 further
116 Foreign trade
worsened the situation and consequently, foodgrains imports worth Rs.1,201

crores were made during the three years, i.e., 1966-67 to 1968-69. During the
Fourth Plan, a declining trend in food imports was observed. Food import bill
which was of the order of Rs.184 crores in 1969-70 went down to as low a
figure as s.28 crores only. But these were four good crop years. The trend
was reversed in 1973-74 when food imports of the order of Rs.548 crores
were made during the period 1974-75 to 1979-80. With a bumber crop of
foodgrain and with a large buffer stock created foodgrain imports have dwindled
since then. During the 5 year period (1980-81 - 1984-85) foodgrains imports
averaged about Rs.374 crores per annum. In 1987-88, foodgrains worth Rs.66
crores were imported - a negligible figure indeed. But during 1992-93, they
again rose to Rs.1,240 crores. Even during 2004-05, foodgrains worth only
Rs.2,170 crores were imported.
Machinery
Imports of machinery include electrical and non-electrical equipment as also

locomotives, imports of machinery are bound to increase. Compared to the
average annual import of machinery which was about Rs.191 crores during
the 1951-61 to 1960-61, the annual average during the Third Plan rose to
Rs.472 crores. During 1974-75 and 1979-80, value of machinery imports
averaged Rs.1,078 crores. Machinery imports averaged nearly Rs.2,515 per
annum during 1980-81 to 1984-85. their annual average jumped to Rs.6,415
crores during the Seventh Plan (1985-86 to 1989-90). Machinery imports further
went up to Rs.29,433 crores during 2004-05. The increasing import of
machinery is an indicator of our growing industrialisation as well as our failure
to develop our own technology and indiscriminate liberalisation in import policy.
Minerals Oils
Imports of mineral oils are also on the increase. India is short in the supply of
mineral oils, especially petroleum. Annual import of mineral oil during 1969-70
to 1973-74 averaged Rs.226 crores. On account of the sharp increase in the
prices of crude announced by the Organisation of Petroleum Exporting
Countries, during 1973-74 alone, petroleum imports were of the order of Rs.569
crores. Their annual average during 1974-75 to 1979-80 was of the order of
Rs.2,063 crores. During 1980-81 to 1984-85 imports of petroleum, oil and
lubricants rose to very high level - the average annual value of POL import bill
was Rs.5,264 crores. During 2004-05, import of mineral oils reached a record
level of Rs.1,34,094 crores.
Metals
India imports iron and steel and also some non-ferrous metals. The annaul average
imports of ferrous and non-ferrous metals which were about Rs.54 crores during
the First Plan have gone up steadily with every plan and were about Rs.2,450
crores during 1985-86 and 1989-90. Import of metals on such a large scale is
necessitated by the vast programmes of industrial expansion, development of
railways and hydro-electric projects. With improvement in capacity utilisation of
our steel plants, imports of iron and steel should be cut down. During 2004-05,
metals worth Rs.9,825 crores were imported on in average.
Chemicals, drugs and medicines
There has been an increase in the imports of chemicals, drugs and medicines.
The annual average of these items was about Rs.55 crores during the Third
Plan. Imports of chemicals, drugs and medicines rose to Rs.113 crores per
annum on the average during the Fourth Plan. During 1980-81 and 1984-85
annual average imports of this item rose to Rs.660 crores. It further rose to
Rs.1,868 crores during 1985-86 and 1989-90. They rose further to Rs.4,977
crores during 2001-05.
Pearls and previous stones
The import of pearls and previous stones averaged Rs.223 crores during 1974-
79 and they have further increased to Rs.2,405 crores per annum for the
period 1985-86 to 1989-90. Part of these imports is meant to satisfy the demand
of the affluent sections and part of these imports serve as raw materials for
the handicrafts export industry. It may be noted that the exports of pearls and
previous stones were of the order of Rs.61,581 crores during 2004-05, as
against an import of Rs.42,340 crores.
Fertilisers
Following the adoption of the New strategy in Indian agriculture, the imports of
fertilizers were stepped up. The average annual imports of fertilizers which
stood at Rs.28 crores during the Third Plan rose to Rs.121 crores during
118 Foreign trade
1966-67 to 1968-69 but with the increase of domestic production of fertilizers,

imports on account of this item declined to an annual average of Rs.96 crores
during the Fourth Plan. With a sharp increase in the international prices during
teh Fifth plan were of the order of Rs.423 crores. During 1980-81 to 1984-85,
the annual imports of fertilizers rose further to of Rs.698 crores. As a
consequence of liberalisation, fertilizer imports jumped to Rs.1,436 crores in
1985-86 and were of the Rs.1,114 crores per annum on an average during
1985-86 to 1989-90. Imports of fertilizers were of the order of Rs.3,707 crores
during 2001-05.
Pattern of Exports
Exports of India are broadly classified into four categories : (i) Agriculture and
allied products which include coffee, tea, oil cakes, tobacco, cashew kernels,
spices, sugar, raw cotton, rice, fish and fish preparations, meat and meat
preparations, vegetable oils, fruits, vegetables and pulses ; (ii) Ores and
minerals include manganese ore, mica and iron ore; (iii) Manufactured goods
include textiles and ready-made garments, jute manufacturers, leather and
footwear, handicrafts including pearls and previous stones, chemicals,
engineering goods and iron steel; and (iv) mineral fuels and lubricants.
Reveal that traditional exports dependent upon agriculture and mineral wealth
accounted for 42 per cent of total exports in 1970-71, their share has, however,
declined to 10.1 per cent in 2004-05. As against it, the share of manufactures
has gone up from about 50 per cent in 1970-71 to about 73 per cent in 2004-
05. Obviously, the structure of Indian exports is changing in favour of
manufactured goods.
Exports of Principal Commodities
Tea and Coffee
Tea and coffee are important items of Indian exports. Tea had the first position
in our exports in certain years. The average annual exports of tea were Rs.106
crores during the First Plan period. Tea exports further picked up to touch
Rs.195 crores in 1960-61.
But later they declined. Tea exports earned Rs.1,132 crores during 1991-92,
but their contribution rose to 1,784 crores in 2004-05.
During 2004-05, coffee exports touched a record level of Rs.1,008 crores.
Cotton Yarn and Manufactures
During the First Plan period, the average annual exports of cotton yarn and
manufactures touched Rs.81 crores, but they declined to a small figure of
Rs.55 crores during the Third Plan. On account of relatively high cost in Indian
textile industry. India found it difficult to capture the international market. In
fact high costs were due to rising labour costs and use of old and worn-out
machinery. In the post-devaluation period exports of cotton textiles have
increased on account of their competitiveness in the international market.
During 1970-71 and 2004-05 exports of cotton (yarn and manufactures)
improved from Rs.75 crores to Rs.14,390 crores.
Readymade garments
In recent years, the exports of cotton apparel or ready-made garments have

shown significant improvement. These exports were just Rs.9 crores in 1970-
71. They jumped to Rs.196 crores in 1974-75. During 2004-05, cotton apparel
exports touched a record of Rs.27,077 crores. This indicates the increasing
importance of this item in our exports.
Leather and leather manufactures
One of the traditional items of Indian export is raw hides and skins. But recently,
in the exports of this item, the proportion for leather and leather manufactures
to raw hides and skins is on the increase. This is really a healthy development.
India earned about Rs.39 crores in 1960-61 from this item. It touched Rs.486
crores in 1979-80 and rose further to Rs.10,286 crores during 2004-05.
Sl.No. Items 1960-61 1970-71 1980-81 1985-86 1990-91 2004-05

1. Coffee 2 25 214 265 252 1,008
2. Tea 195 148 426 626 1070 1,784
3. Fruits and Vegetables 7 18 116 206 335 2,895
4. Cotton yarn and 91 75 277 574 2100 14,390
manufactures
5. Leather and leather 39 72 337 770 2566 10,286
manufactures
6. Iron ore 27 117 303 579 1049 11,815
7. Tobacco 25 33 141 170 263 1,247
8. Engineering goods 13 130 727 954 3877 73,870
120 Foreign trade
9. Cashew kernel 30 52 140 225 447 2,348

10. Readymade garments n.a. 9 378 1067 4012 27,077
11. Handicrafts (including n.a. 70 894 1881 6167 63,124
gems for jewellery)
12. Fish and fish preparation 7 31 213 409 960 5,695
13. Rice - 5 224 196 462 6,62
14. Chemicals and allied - - - - 3,558 53,347
products
Iron Ore
India exports iron ore. India earned about Rs.30 crores per year from iron ore
during the First Plan. During 1970-71 exports of iron ore rose to Rs.117 crores
and touched Rs.11,815 crores during 2004-05. This is an unhealthy
development. India should increase the share of steel in exports by utilising
iron ore in her own steel plants.
Handicrafts
The exports of Indian handicrafts assumed great importance in the 1970’s.
From a low level of Rs.70 crores in 1970-71 they increased to Rs.120 crores
in 1972-73 and stood at Rs.29,330 crores in 1998-99. The most important
item among the handicrafts was pearls and precious stones which averaged
Rs.3,177 crores during 1985-86 to 1989-90. At present, the single largest item
of export is handicrafts. During 2004-05, handicrafts exported were of the
order of Rs.63,124 crores out which gems and jewellery accounted for
Rs.61,581 crores.
Engineering goods
The exports in this category also include iron and steel, electronic goods and
computer software. Even upto 198-81, exports of this group were a meager
Rs.827 crores, but these exports started picking up and by 1990-91, they
were of the order of Rs.3,872 crores. During 2004-05, these exports have
shot up to Rs.73,870 crores, accounting for 20.7 per cent of total exports.
This is a commendable achievement.
Changing structure of Exports
The structure of Indian exports is typical of a developing economy. India has

traditionally been an exporter of agricultural raw materials and manufactures
based on agricultural raw materials. There has been a continuous decline in

the share of agricultural raw materials and allied products. One reason for the
relative decline of food, beverages and tobacco in the total exports is the
increase in population and consequent increase in domestic consumption of
these goods. Accordingly, the export surplus in many traditional commodities
like tea has not been increasing as much as the government would have
wished. In this connection, the growing importance of certain products in this
category should be noted, i.e. fish and fish products, cashew kernels, coffee
and rice, vegetables and fruits are also growing in importance.
Since 1960, under the impact of industrialisation, exports of non-traditional

items are gaining in importance. These items consist of engineering goods,
handicrafts, which include pearls, previous and semi-precious stones and
Jewellery, iron and steel, iron-ore, chemicals, readymade garments, fish and
fish preparations. These goods constitute more than 66 per cent of India’s
exports now. The fact that some of these non-traditional items - such as
engineering goods, handicrafts, ready-mades, etc. - have established
themselves in the markets of even the most advanced countries shows that
they would continue to be part of India’s export effort has been commendable
but not consistent enough.
We should not, however, conclude that only non-traditional items are to the
fore and the traditional items have suffered a retreat. Exports of traditional
items are also expanding, though probably not to the extent desired. Examples
are the respectable growth in cotton fabrics, tea, leather and leather
manufactures etc.
(a) The pattern of India’s exports indicates that (a) the Indian economy is
being diversified and (b) non-traditional items of exports are growing in
importance.
(b) The large expansion of engineering goods partly the result of pick-up
in demand in industrial countries and also from the Middle East
countries which have undertaken infra-structural projects like roads,
ports and rail construction, tele-communication and civil construction.
(c) Indian is now in a position to take advantage of both favourable demand
situation and attractive price situation in international markets.
122 Foreign trade
(d) While some commodities have tremendous exports potential (e.g.

handicrafts, engineering goods and ready-mades), others (like sugar,
jute, yarn and manufactures, iron and steel) have fluctuated widely.
(e) With the announcement of the new agricultural policy, emphasis is
being given to boosting the export of agricultural produce. Rice export
is gaining importance. Besides this, fruits and vegetables and
processed foods are also becoming significant in our exports.
10.1.2 DIRECTION OF INDIA’S FOREIGN TRADE
In order to study the regional direction of India’s foreign trade, it would be
appropriate to classify the world into four broad groupings; viz., America, Europe,
Asia and Oceania and Africa.
So far as the American continent is concerned India had strong trade relations
with North America comprising U.S.A. and Canada. Really speaking, U.S.A. is
the dominant country in America. The countries of Latin America and other
American countries did not develop trade relations of much significance. That
in 1951-52 India exported over 28 per cent of her goods to America, out of
which 21 per cent were sent to North America and 7 per cent to Latin America.
The share of Latin American countries declined over the years and they
accounted for less than 1 per cent in 1979-80. The share of North America
was 19 per cent in 1969-70. But after the Bangladesh war in 1971, relations
between India and the U.S.A. were strained and trade between the two countries
declined. This explains to a great extent the fall in our exports to U.S.A. in the
1970’s. During recent years, the position has slightly improved and exports to
U.S.A. were 16.7 per cent of total exports in 2004-05. On the side of imports,
USA contributed 36 per cent in 1951-52, its share fell to 32 per cent in 1960-
61, rose to 40 per cent in 1965-66 largely due to foodgrain imports, and was
about 35 per cent in 1969-70. As a reaction to the hostile attitude of USA during
the Bangladesh war, India decided to reduce her dependence on USA and
thus imports from USA accounted for 10.4 per cent total imports in 1981-82.
The share of USA in our imports has been declining over the years and was
only 5.9 per cent during 2004-2005.
Historically, India had close trade relations with U.K. It also had trade relations
with other countries of Europe. For purposes of trade, the continent of Europe
may be grouped under three broad regions : Western Europe, Eastern Europe
and other European countries : Western Europe get divided into two broad
categories the European Market (ECM) and European Free Trade Area (EFTA).
In 1950-51, out of 31.5 per cent of the total Indian imports from Europe, 30.5
per cent came from Western Europe. The share of Western Europe increased
to 49 per cent in 1955-56. Two factors were responsible for this : firstly, imports
from U.K. increased because she had to pay her sterling debt to India and
secondly, the share of ECM countries, more especially, West Germany
increased sharply in our imports. Since U.K. decided to join ECM in 1973, the
importance of EFTA countries dwindled to barely 1.6 per cent in our total
imports. The share of ECM countries declined from 18.2 per cent in 1955-56
to 10.9 per cent in 1969-70. However, part of the increase is a mere shift from
the EFTA region. But if we take EFTA and ECM together, the share of European
Economic Community (EEC) has been on the decline since 1955-56 and
came down to 21 per cent in 1976-77. However, it improved to 25 per cent in
1998-99 but again declined to 16.5 per cent in 2004-05.
Our trade with East European Socialist countries viz., U.S.S.R. Poland,
Romania, Bulgaria, Hungary, East Germany, Czechoslovakia and Yugoslavia
developed in during the sixties. In 1960-61, India imported 4 per cent of her
total imports from this region and exported about 8 per cent of her total exports
to this region. But soon after the Indo-Chinese conflict in 1962 and Indo-Pak
war in 1965, out trade relations with the East European Socialist countries
improved remarkably. In 1969-70 this group of countries accounted for 18 per
cent of total imports and about 72 per cent of our exports. U.S.S.R. as the
chief contributor accounted for nearly 84 per cent of trade with this region.
Our trade with the countries in Asia and Oceania (other OECD countries) has
been of great significance. Our exports to these countries which were about
28 per cent of total imports in 1951-52 increased on 32 per cent in 1969-70.
As against it, imports from these countries declined from about 23 per cent in
1951-52 to 19 per cent in 1969-70. The ECAFE region was of great significance
and two countries, viz., Japan and Australia were very important.
The share of Japan and Australia in our exports which was about 15 per cent
in 1970-71 has come down in 3.2 per cent in 2004-05. As against it, the share
in our imports from these two countries has declined from 9.2 per cent to 6.1
per cent during the same period.
124 Foreign trade
However, due to increasing importance acquired by the imports of crude oil,

OPEC countries have assumed very great significance in our imports. These
countries accounted for barely a per cent in our total imports in 1970-71 per
cent. Much of the increase was due to the sharp hike in the price of oil and did
not indicate a corresponding increase in the quantity index of imports. On the
export front also our exports to PEC countries increased from 64 per cent in
1971-72 to 16.0 per cent in 2004-05. With a fall in the international price of oil,
the share of OPEC countries in our imports declined 8.6 per cent in 1986-87
and still further to 6.8 per cent in 2003-04 but the recent hike in the price of
petroleum has again pushed up the share of OPEC to 9.1 per cent in 2004-05.
India had a great potential for increasing her foreign trade with Asian countries,
because the Indian manufactures are readily acceptable in these countries.
Similarly, India can import raw materials for her growing industries from these
relatively less-developed regions. This is evidenced by the fact that during
2004-05, imports from this region accounted for 25.4 per cent of our total
imports whereas they were in the range of 3.3 per cent in 1970-71. On the
export side, there has been gradual an steady improvement and exports to
this region increased from 10.8 per cent during 1970-71 to a high level of 37.3
per cent in 2004-05.
With Africa, our exports have remained, more or less constant to a level of
about 6.7 per cent during 1951-52 to 1970-71, but declined thereafter and
stood at 5.4 per cent in 2004-05. However, on the import front, the share of
African countries has been fluctuating from 9 per cent since 1951-52 but it
has declined to a low level of 3.4 per cent in 2004-05.
Taking an overall view, it can be stated that India developed by the eighties a
more spatially dispersed pattern of foreign trade. It excessive dependence on
Western Europe and North America witnessed a gradual decline during the
period 1951-52 to 1969-70 and there was shift in favour of East European
Socialist countries and Asian countries, especially OPEC countries. But during
the eighties and the period of 1990-91 to 2004-05 which witnessed the
disintegration of the Soviet Union into commonwealth of Independent states,
the importance of Western Europe and North America has increases sharply.
They together account for 44 per cent of our exports and 35 per cent of our
imports in 2004-05. The share of Eastern Europe has dwindled to a mere
trickle and those developing countries of Asia and Africa is increasing.
It would be of interest to examine the direction of trade with reference to some

important countries. U.S.A., U.K., Germany, Japan, Saudi Arabia, UAE and
Netherland were the 7 countries of significance in our trade. The share of
these 7 countries in our exports had declined from 57 per cent to 40 per cent
during 1951-52 to 2004-05. As against it, their share in our imports has ranged
between 45 to 22 per cent during this period.
During 1987-88 and 2004-05, significant changes in the direction of India’s
foreign trade have been witnessed. The major changes are :
(i) Exports to OECD countries which were of the order of about 59 per cent
in 1987-88 have declined sharply to 44 per cent in 2004-05. Similarly, there
has been a still sharper decline in imports from OECD countries from about
60 per cent in 1987-88 to 35.1 per cent in 2004-05. The declining is universally
observed in European Union, North America (including USA) and other OECD
countries like Australia, Japan and Switzerland.
(ii) India’s trade with developing countries of Asia, Africa and Latin America
has shown an upward trend. The exports to developing countries which were
only 14.2 per cent in 1987-88 shot up to 37.3 per cent in 2004-05. In this, there
is marked improvement in exports to countries of Asia whose share improved
significantly from 12 percent to 29.3 per cent during this period. In this, China
and Hong Kong shared about 10 per cent of our exports, followed by SAARC
region 5.4 per cent.
10.1.3 MULTINATIONAL CORPORATIONS
An MNC is one which undertakes FDI, i.e., it owns or controls income generation
assets in more than one country, and in so doing produces goods or services
outside its country of origin, i.e., engages in international production.
Characteristics of Multinational Corporation
The MNCs are multi-process, multi-product and multi-national composite
enterprise.
Giant size : The assets and sales of MNCs run into billions of dollars and
they also make supernormal profits.
à Exxon, with estimated value-added of $ 63 bn, is about the same size

as the economy of Pakistan and larger than Peru’s, while Ford, Daimler
Chrysler, General Electric and Toyota are all comparable in size to the
economy of Nigeria.
126 Foreign trade
à The Economist guesstimates that the world’s top 300 MNCs now control
over 25 per cent of the $20 trillion stock of productive assets.
à No size, however, big, is perceived to be sufficient. And hence the
MNCs keep on growing, even through the route of mergers and
acquisitions.
International Operations: In such a corporation control resides in the hands
of a single institution. But its interests and operations sprawl across national
boundaries. MNCs have become in effect global factories searching for
opportunities anywhere in the world.
An MNC operates through a parent corporation in the home country. It may

assume the form of a branch or a subsidiary in the home country. It if is a
branch, it acts for the parent corporation without any local capital or
management assistance. If it is subsidiary, the majority control is still exercised
by the foreign parent company, although it is incorporated in the home country.
The foreign control may range anywhere between the minimum of 51 per cent
anywhere between the minimum of 51 per cent to the full 100 per cent. An
MNC thus combines ownership with control.
Oligopolistic Structure: Through the process of merger and take over, etc.,
in course of time an MNC acquires awesome power. This coupled with its
giant size makes it oligopolistic in character.
Spontaneous evolution: MNCs usually grow in a spontaneous and

unconscious manner. Very often they develop through creeping incrementalism.
Many firms have become international by accident. At times, firms have also
established subsidiaries abroad due to wage differentials and better
opportunities prevailing in the home country.
Collective Transfer of Resources: An MNC facilitates a multilateral transfer

of resources. Usually this transfer takes place in the form of a package which
includes technical know-how, equipments and machinery, raw materials,
finished product, managerial services, and so on. MNCs are composed a
complex of widely varied modern technology ranging from production and
marketing to management and finance.
Significance of Multinational Corporation
With the retreat of socialism and failure of aid as an instrument of economic

development, there has been a greater realisation of the capacity of MNCs to
deliver an efficient package of practices. In the 1970s MNCs were characterised
by alarmists as something of an evil monster - almost like muggers on a dusk
night waiting to pounce on the innocent passerby. MNCs were seen as pariahs,
not saviours - objects of harm, not instruments for good. These attitudes have
changed in the last few years. Today they constitute a powerful force in the
world economy.
The case for multinational corporations
The case for MNCS revolves around the potential benefits that a UDC can hope
to get from MNC operations. These benefits are summarised in the table below :
Potential Benefits from MNC Operations
Impact Area Potential Benefits
Capital Provision of scarce capital resources
- internally generated
- externally generated
(privileged access to global capital markets)
Technology Provision of sophisticated technology and other
technology not available in the host country.
Exports and Access to superior global distribution and marketing

balance of systems- MNCs may increase exports and create positive
payments balance of payments effects
Diversification MNCs command technology and skills required for

diversification of the industrial base and for the reation
of backward and forward linkage.
A recent study on the subject concludes that in today’s world of global capitalism
foreign investment is the only instrument that can reduce the inequalities
between nations.
128 Foreign trade
The case against multinational corporations
In actual operations, in the past half a century or so, the experience of UDCs
with MNCs has been none-too-happy. Main points of criticism can be
summarised as in Table.
Actual impact of MNC Operations
Capital Insignificant net inflow

- The MNCs raise most of the investment capital in
domestic capital market, pre-empt scarce local capital
resources and crowd out domestic borrowers.
Large dividend remittances
Large technical paymentsProgressive fall of foreign
participation in corporate capital formation.
Technology Transitory reluctance followed by increased inflow.
But :
Costly over - import
Problems with advanced technology and updating
Problems with technical support
Export Export performance on par with domestic companies
Higher import propensity than domestic companies.
Some import substitution but negative BOP effects.
Diversification MNCs do contribute: reallocation in favour of
manufacturing and technology intensive sectors.
But :
Preemption of growth opportunities and substitution of
domestic capital in several promising areas.Increased
foreign influence in key sectors.
In a partial response to the above propositions it may be stated that many of

the old myths are not longer valid. Present-day Third World Governments are
not exactly powerless like those of yesteryears, nor are the modern MNCs
mere white profiteers who would turn into predators, unscrupulous, insensitive
and interventionist. They are not like large trading firms of the 19th century,
such as the East India company or the Royal African company which were
like dinosaurs, large in bulk but small in brain, feeding on the lush vegetations
of the new worlds. They have transformed themselves into modern MNCs
which acknowledge their responsibility to the concerns and interests of the
host countries and basically operate on the basis of mutuality of interests of
both. MNCs are increasingly losing the sense of loyalty to their home country
to provide employment. They are in search of bases where they can produce
their products most competitively. The chosen model of growth is being defined
as micro-multinational, i.e., a company that from its very inception is based in
a developed country but maintains a less-costly skill workforce abroad. The
slogans Think global, act local and multi-domestic are a working reality with
most multinationals today. In fact, in present times international capital has no
loyalty towards any nationality. MNCs realise they cannot be oriented toward
the state of their origin. They have to be the citizens of the country they are in.
If they are not, they do not succeed.
In view of these, there has been a perceptible change in the attitude of the a
UDCs towards the MNCs, more particularly after the onset of the world debt
crisis in the second half of 1980s and the resultant Baker Plan (named after
the US Secretary of the Treasury, James A. Baker III who presented such a
plan during a major address to the Annual Meeting of the IMF and World Bank
held in Seoul in October 1985) which emphasised the urgency for augmenting
non-debt creating capital flows to the UDCs. The MNCs have been seen as
the carriers of this potential. Hence UDCs are focusing on measures that
facilitate business. These include investment promotion, investment incentives,
and after-investment services, improvements in amenities and measures that
reduce the basic cost of doing business.
10.1.4 RECENT TRENDS IN FOREIGN TRADE

The data reveal that during 1999-2000, exports rose by 13 per cent in dollar
terms, but there a statistical fallacy in this figure, since exports had declined
to # 33.219 million in 1998-99. There are several factors contributing to this
situation. Firstly, India underestimated the impact of South-East Asian crisis
during 1997-98, but this is now considered to be a major contributing factor
among the causes of export growth slump. Although India’s trade with this
region accounts for only 8 per cent of India’s total export growth, but its indirect
effects have to be taken into account. Secondly, there is an increasing
130 Foreign trade
competition from China and Taiwan. Thirdly, exports of textiles have also been
affected by the restrictive and protectionist policies of developed countries on
the one hand and increasing competition from China on the other. Fourthly,
large industrial houses have miserably failed to boost exports. A study of 500
top companies made by Commerce Ministry has revealed that large industrial
houses account for only 5 per cent of total exports, while their import intensity
is very high. In other words, large industrial houses are net losers of foreign
exchange. Fifthly, the service sectors in the Indian export market have made
some headway, for instance, software exports rose to record level of Rs.53,912
crores in 2003-04 and their contribution to export effort was commendable.
Sixthly, non tariff barriers have been created by the developed countries to
slow down Indian exports. The uses of anti-dumping duties by these countries
have also affected exports.
During 2000-01, exports increased from US $ 36,822 million in 1999-2000 to

US $ 44,560 million in 2000-01, showing a sharp rise by 21.0 per cent. this
was largely due to rupee depreciation along with further trade liberalisation,
reduction in tariffs and more openness to foreign investment in export oriented
sectors like information technology. However, on the import side, during 1999-
2000 and 2000-01, there has been a sharp increase in the international price
of crude oil. This has resulted in a sharp escalation of the POL (petroleum, oil
and lubricants) imports from US $6.399 million in 1998-99 to US $ 9.607 million
in 2000-01, implying an increase of 63 per cent during 2000-01, implying an
increase of 63 per cent during 2000-01 over the previous year. The sharp
increase in POL imports prevented non POL imports to increase adequately.
Non-POL imports just rose by 11.3 per cent during 1999-2000 from US $
35,990 million in 1998-99 to US $ 40.064 million in 1999-2000, but declined by
14.9 per cent in 2000-01 to US $ 34,450 million. This implies that the increase
in POL imports resulted in depressing the rise of non-POL imports so as to
keep total imports within manageable limits.
Restriction of imports to a level of 1.7 per cent as against the increase in exports
by 21.0 per cent helped the country to reduce the deficit in balance of trade to
US $ 5.976 million in 2000-01 as against US $ 12,849 million in 1999-2000.
Although in 2005-06, exports increased by 24.7 per cent, but rise in imports by
31.5 per cent resulted in the trade deficit to be of the order of $ 39.6 billion - a
record trade deficit. The situation became much worse in 2005-06 and imports
touched a record level of $ 140.2 billion. There has been a sharp increase in
both POL and non-POL imports, although during 2004-05 and 2005-06. POL
imports rose at a very sharp rate a against non-POL exports.
CHECK YOUR PROGRESS
1. The Indian Foreign Trade has become much more diversified and
excessive dependence on OECD countries has declined.
2. Tea and coffee are important items of Indian exports.
3. During 2004-05, Foodgrains worth only Rs.2,170 crores were imported.
4. Pepsi and Coke are the multinationals in India.
SUMMARY
The MNCs are multiprocess, multiproduced and multinational composite

enterprises. The assets and sales of MNCs run into billions of dollars and they
also make supernormal profits. Imports have now been classified into Bulk
imports and non-bulk imports. Bulk imports are further subdivided into three
components (1) Petroleum, Crude and Products (2) Bulk consumption goods
which comprise of cereals and pulses edible oils and sugar (3) Other bulk
items. Non bulk imports are classified into 3 components (1) Capital goods
(2) Pearls, previous and semiprecious stones (3) Others include artificial resins
and plastic materials, coal and coke Exports or India are classified into four
categories (1) Agriculture and allied products(2) Ores and minerals (3)
Manufactured goods (4) Mineral fuels and lubricants.
GLOSSARY
MNC : An MNCs is one which under takes FDI i.e. it owns and controls income
generation assets in more than one country and in so doing produce goods or
services outside its country of origin i.e. engages in international production.
POL imports : Petroleum, Oil and Lubricant imports.

132 Foreign trade
MODEL QUESTIONS
1. Bring out the role of MNCs in India.

2. Write a note on composition of India’s Foreign trade.
3. Explain the concept direction of India’s Foreign trade.
4. Recent trends in India’s Foreign Trade Elucidate.
BOOKS FOR REFERENCE

2. Sankaran, International Economics.
BLOCK - IV
FOREIGN EXCHANGE MARKET AND EXCHANGE CONTROL
Unit 11 : Foreign exchange
Unit 12 : Exchange control

134 Foreign Exchange
UNIT 11
FOREIGN EXCHANGE
STRUCTURE
Overview
Learning Objectives
11.1 Foreign Exchange
11.1.1 Meaning of Foreign Exchange
11.1.2 Determination of foreign exchange
11.1.3 Causes for the fluctuation in Foreign Exchange
11.2 Fixed Exchange Rates
11.2.1 Meaning of Fixed Exchange Rate
11.2.2 Case of fixed exchange rates
11.2.3 Case against Fixed Exchange Rates
11.3 Flexible Exchange Rates
11.3.1 Meaning of Flexible Exchange rate
11.3.2 Case of Flexible Exchange rates
11.3.3 Case against Flexible Exchange Rates
Summary
Glossary
Model Questions
Books for Reference
OVERVIEW
In this unit, you are going to learn the meaning of exchange rate and how
exchange rate is determined. If further explains the causes for the fluctuation
in exchange rate. Merits of stable exchange and demerits of stable exchange
rate are explained. It also focuses upon flexible exchange rate and the merits
and the demerits of flexible exchange rate.
LEARNING OBJECTIVES
Ø explain the meaning of exchange rate determination

Ø list out the concepts of DD and SS of Foreign exchange
Ø state the merits and demerits of exchange rate
Ø describe the merits and demerits of flexible exchange rate
Ø explain the concept of exchange control
Ø describe the methods of exchange control
Ø discuss the merits and demerits of exchange control
11.1 FOREIGN EXCHANGE
11.1.1 MEANING OF FOREIGN EXCHANGE

The foreign exchange rate or exchange rate is the rate at which one currency
is exchanged for another. It is the price of one currency in terms of another
currency. It is customary to define the exchange rate as the price of one unit of
the foreign currency in terms of the domestic currency. The exchange rate
between the dollar and the pound refers to the number of dollars required to
purchase a pound. Thus the exchange rate between the dollar and the pound
from the US viewpoint is expressed as $2.50 = £1.
11.1.2 DETERMINATION OF FOREIGN EXCHANGE

The exchange rate in a free market is determined by the demand for and the
supply of foreign exchange. The equilibrium exchange rate is the rate at which
the demand for foreign exchange equals to supply of foreign exchange. In
other words, it is the rate which clears the market for foreign exchange. Ragner
Nurkse defined the equilibrium exchange rate as, “that rate which over a certain
period of time, keeps the balance of payments in equilibrium”. There are two
ways of determining the equilibrium exchange rate. The rate of exchange
between dollars and pounds can be determined either by the demand and
supply of dollars with the price of dollars in pounds, or by the demand and
supply of pounds with the price of pounds in dollars.
11.1.3 CAUSES FOR THE FLUCTUATION IN FOREIGN EXCHANGE

The demand for foreign exchange is a derived demand from pounds. It arises
from import of British goods and services into the US and from capital
movements from the US to Britain. In fact, the demand for pounds implies a
supply of dollars. When the US businessmen buy British goods and services
and make capital transfer to Britain, they create demand for British pounds in
exchange for US dollars because they cannot make payments to Britain in
their currency, the US dollars.
The demand curve for pounds DD is downward sloping from left to right in the
Figure 1. It implies that the lower the exchange rate on pounds, the larger will
be the quantity of pounds demanded in the foreign exchange (US) market,
and vice versa. This is because a lower exchange rate on pounds makes
British exports of goods and services cheaper in terms of dollars. The opposite
happens if the exchange rate on pound is higher. It will make British goods
and services dearer in terms of dollars, and the demand of pounds will fall in
the foreign exchange (US) market.
But the shape of the demand curve for foreign exchange will depend on the
elasticity of demand for imports. “If a country imports necessities and raw
materials, we may expect the elasticity of demand for imports to be low and
the quantity imported to be insensitive to price changes.
The Supply of Foreign Exchange
The supply of foreign exchange in our case is the supply of pounds. It arises
from the US exports of goods and services and from capital movements from
the US to Britain. Pounds are offered in exchange for dollars because British
holders of pounds wish to make payments in dollars. Thus the supply of foreign
exchange reflects the quantities of pounds that would be supplied in the foreign
exchange market at various dollars prices of pounds.
The supply curve for pounds SS is an upward sloping curve, as shown in the
Figure 1. It is a positive function of the exchange rate on pounds. S the
exchange rate on pounds increases, the greater is the quantity of pounds
supplied in the foreign exchange market. This is because with increase in the
dollar price of pounds (Lower pounds price of dollars), US goods, services
and capital funds become better bargains to holders of pounds. Therefore the
holder of pounds will offer larger quantities of pounds with the increase in the
exchange rate.
Fig.No. 1 Quantity of Foreign Exchange

But the shape of supply curve of foreign exchange will be determined by the
elasticity of the supply curve. “As the value of the country’s own currently
increases, imports become relatively cheaper, and more is imported. As more
is imported, more of the home currency is supplied on the foreign exchange
market, provided elasticity is greater than unity. When imports become relatively
cheap, new goods will start to be imported, and domestic import-competing
industry will be gradually eliminated by imports. These are two important
reasons why we expect the supply of foreign exchange to be quite elastic.
Further, the larger the time perspective we take into account, the more elastic
will be the supply”.
11.2 FIXED EXCHANGE RATES
11.2.1 MEANING OF FIXED EXCHANGE RATE

Under fixed or pegged exchange rates all exchange transactions take place at
an exchange rate that is determined by the monetary authority. It may fix the
exchange rate by legislation or intervention in currency markets. It may buy or
sell currencies according to the needs of the country or may take policy decision
to appreciate or depreciate the national currency. The monetary authority
(central bank) holds foreign currency reserves in order to intervene in the
foreign exchange market, when the demand and supply of foreign exchange
(say pounds) are not equal at the fixed rate.
11.2.2 CASE OF FIXED EXCHANGE RATES

Fixed exchange rates have the following advantages:
i. Based on Common Currency
The case for fixed exchange rate between different countries is based on the
case for a common currency within a country. A country having a common
currency with a fixed value facilities trade increases production and leads to
faster growth of the economy. Similarly, a country would benefit if it has a fixed
value of its currency in relation to other countries. Thus fixed exchange rates
encourage international trade by making prices of goods involved in trade more
predictable. They promote economic integration. As pointed out by Johnson.
“The case for fixed rates is part of a more general argument for national
economic policies conductive to international economic integration”.
ii. Encourage Long Term Capital Flows
The second argument for a system of fixed exchange rates is that it encourages
long term capital flows in an orderly and smooth manner. There is no uncertainty
and risk resulting from a regime of fixed exchange rates.
iii. No Fear of Currency Fluctuations
There is no fear of currency depreciation or appreciation under a system of
fixed exchange rates. For instance, it removes fear that holding large quantities
of foreign currency might lead to losses, if a currency’s value drops. Thus it
creates confidence in the strength of the domestic currency.
iv. No Adverse Effect of Speculation
There is no fear of my adverse effect of speculation on the exchange rate, as
speculative activities are controlled and prevented by the monetary authorities
under a regime of fixed exchange rates.
v. Disciplinary
Another advantage claimed by a system of fixed exchange rates is that it
serves as an ‘anchor’ and imposes a discipline on monetary authorities to
follow responsible financial policies with countries. “Inflation will cause balance
of payments deficits and reserve loss. Hence the authorities will have to take
counter-measures to stop inflation. Fixed exchange rates should, therefore,
impose ‘discipline’ on governments and stop them from pursuing inflationary
policies which are out of tune with the rest of the world”.
vi. Best for Small Countries
Johnson favors fixed exchange rates in the ‘banana republics’ where foreign
trade plays a dominant role. Flexible exchange rates in them lead to inflation
and depreciation when the exchange rate falls.
vii. Less Inflationary
It leads to greater monetary discipline and so to less inflationary pressures.
viii. Certainty
Fixed exchange rates create certainty about foreign payments among exporters
and importers of goods because they know what they have to receive or pay
in foreign exchange.
ix. Suitable for Common Currency Areas
This system is suitable for common currency areas such as Euro, Dollar, etc.
where fixed exchange rates promote growth of world trade.
x. Promotes Money and Capital Markets
It promotes the development of international money and capital markets and

helps the flow of capital among nations.
xi. Multilateral Trade
This system encourages multilateral trade globally among countries because

countries have no fear of wide fluctuations in exchange rates.
xii. International Monetary Co-operation
The system of fixed exchange rates promotes international monetary co-

operation and so helps in the smooth working of the international monetary
system under such institutions as IMF, World Bank, Euro-Market.
11.2.3 CASE AGAINST FIXED EXCHANGE RATES

The following arguments are advanced against a system of fixed exchange
rates:
i. Sacrifice of Objectives
The principle defect in the operation of a system of fixed exchange rates is the
sacrifice of the objectives of full employment and stable prices at the alter of
stable exchange rates. For example, balance of payments adjustment under
fixed exchange rates of a surplus country can take place through a rise in
prices. This is bound to impose large social costs within the country.
ii. Unexpected disturbances
Under this system, the effects of unexpected disturbances in the domestic

economy are transmuted abroad. “While a country may be protected by fixed
exchange rates from the full consequences of domestic disturbances and
policy mistakes, it has to bear a share of the burden of the disturbances and
mistakes of others. For to the extent that excess demand ‘leaks out’ of the
country where it was originally created, it ‘leaks in’ (via a balance of payments
surplus) to that country’s trading partner”.
iii. Heavy Burden
Under, it, large reserves of foreign currencies are required to be maintained.

Countries with balance of payments deficits must have large reserves if they
want to avoid devaluation. If countries wish to remain on the fixed exchange
rate system, they must hold large reserves of foreign currencies. This also
imposes a heavy burden on the monetary authorities for managing foreign
exchange reserves.
iv. Malallocation of Resources
This system requires complicated exchange control measures which lead to

mal-allocation of the economy’s resources.
v. Complex System
This system is very complex because it requires highly skilled administrators

to operate it. It is also time consuming and may lead to uncertain results.
There is always the possibility of mistakes in policy formulation and
implementation.
vi. Comparative Advantage Unclear
Under this system, the comparative advantage of a country is not clear. For
instance, the exchange rate may be so low that a product may see very cheap
to the other country. Consequently, the country may export that commodity in
which it has no comparative advantage. On the contrary with a very high
exchange rate, the country may posses comparative advantage in a product.
vii. Fixed Exchange Rate not always Possible
Another problem relates to the stability of the exchange rate. The exchange
rate of a country vis-à-vis another country cannot remain fixed for sufficiently
long period. Balance of payments problems and fluctuations in international
commodity prices often compel countries to bring changes in exchange rates.
Thus it is not possible to have rigidly fixed exchange rates.
viii. Balance of payments disequilibrium Persists
This system fails to solve the problem of balance of payments disequilibrium.

It can be tackled only temporarily because its permanent solution lies in
monetary, fiscal and other measures.
ix. Dependence on International Institutions
Under this system, a country mostly depends upon international institutions

for borrowing and lending foreign currencies.
x. Problems of International Liquidity
To expand its trade, a country must have adequate international liquidity. To

maintain a fixed exchange rate, the country must have sufficient reserves of
foreign currencies to avoid balance of payments disequilibrium. On the other
hand, excessive international liquidity is also not good for the country because
the resulting extra demand may lead to international inflation.
11.3 FLEXIBLE EXCHANGE RATES
11.3.1 MEANING OF FLEXIBLE EXCHANGE RATE

Flexible, floating or fluctuating exchange rates are determined by market forces.
The monetary authority does not intervene for the purpose of influencing the
exchange rate. Under a regime of freely fluctuating exchange rates, if there is
an excess supply of a currency, the value of that currency in foreign exchange
markets will fall. It will lead to depreciation of the exchange rate. Consequently,
equilibrium will be restored in the exchange market. On the other hand, shortage
of a currency will lead to appreciation of exchange rate thereby leading to
restoration of equilibrium in the exchange market. These market forces operate
automatically without any intervention on the part monetary authority.
Fig.No. 2 Flexible Exchange Rate
This is illustrated in Fig.2 where D and S are the demand and supply curves
of pounds which intersect at point P and the equilibrium exchange rate E is
determined. Suppose the exchange rate rises to E2. The quantity of pounds
supplied OQ2 is more than the quantity demanded OQ2. When pounds are in
excess supply, the price of pounds will fall in the foreign exchange market.
The value of pound in terms of dollars will depreciate. Now less pounds will be
supplied and more will be demanded. Ultimately, equilibrium will be re-
established at the exchange rate E. On the other hand, if the exchange rate
falls to E1, the quantity of pounds demanded OQ4 is more than the quantity
supplied OQ1. When there is a shortage of pounds in the foreign exchange
market, the price of pounds will rise. The value of pound in terms of dollars will
appreciate. The rise in the price of pounds will reduce demand for them and
increase their supply. This process will continue till equilibrium exchange rate
E is re-established at point P.
We study below the case for and against flexible exchange rates.
11.3.2 CASE OF FLEXIBLE EXCHANGE RATES

The following advantages are claimed for a system of flexible exchange rates:
i. Simple operation
A system of flexible exchange rates is simple in the operative mechanism.

The exchange rate moves automatically and freely to equate supply and
demand, thereby clearing the foreign exchange market. It does not allow a
deficit or surplus to build up and eliminates the problem of scarcity or surplus

of any one currency. It also avoids the need to induce changes in prices and
incomes to maintain to restore equilibrium in the balance of payments.
ii. Smoother Adjustments
Under it, the adjustment is continual. The adjustments in the balance of payments
are smoother and painless as compared with the fixed exchange rate
adjustments. In fact, flexible exchange rates avoid the aggravation of pressures
on the balance of payments and the periodic crises that follow disequilibrium in
the balance of payments under a system of fixed exchange rates. There is an
escape from the various corrective measures that are adopted by the
governments whenever the exchange rate depreciates or appreciates.
iii. Autonomy of Economic Policies
Under this system, autonomy of the domestic economic policies is preserved.

Modern governments are committed to maintain full employment and promote
stability with growth. They are not required to sacrifice these objectives of full
employment and economic growth in order to remove balance of payments
disequilibrium under a regime of flexible exchange rates.
iv. Disequilibrium in the Balance of Payments automatically corrected
Since under a system of flexible exchange rates disequilibrium in the balance

of payments is automatically corrected, there is no need to accommodate
gold movements and capital flows in and out of countries.
v. No Need of Foreign Exchange Reserves
There is no need for foreign exchange reserves where exchange rates are
moving freely. A deficit country will simply allow its currency to depreciate in
relation to foreign currency instead of intervening by supplying foreign exchange
reserves to the other country to maintain a stable exchange rate.
vi. Removes Problem of International Liquidity
A system of flexible exchange rates removes the problem of international

liquidity. The shortage of international liquidity is the result of pegged exchange
rates and intervention by monetary authorities to prevent fluctuations beyond
narrow limits. When exchange rates are flexible, speculators will supply foreign
exchange to satisfy private liquidity needs. Individuals, traders banks,
governments and other would, of course, continue to hold liquid assets in the
form of gold or foreign exchange, but these holdings would be working reserves
for purposes other than the maintenance of a fixed external value of the
country’s currency.
vii. No Need of Borrowings and Lending Short-term Funds
As a corollary to the above, when foreign exchange rates move freely, there is
no need to have international institutional arrangements like the IMF for
borrowing the lending short-term funds to remove disequilibrium in the balance
of payments.
viii. Effective Monetary Policy
The system of flexible exchange rates reinforces the effectiveness of monetary
policy. If a country wants to increase output, it will lower interest rates under a
regime of flexible exchange rates, the lowering of interest rates will result in an
outflow of capital, a rise in the spot rate for the currency which will, in turn,
cause exports to rise and imports to fall. The increased exports will tend to
rise domestic prices, or income or both. Thus a favourable trade balance will
reinforce the expansionary effects of lower interest rates on domestic spending,
thereby making monetary policy more effective. The above process will be
reversed if the country wants to fight inflation by raising interest rates. Thus a
country uses monetary policy to achieve domestic objectives rather than
external balance.
ix. Mistakes Avoided
As a corollary, with automatic adjustments of balance of payments, there is
no possibility of making monetary, fiscal and administrative policy mistakes.
x. Does not Require complicated Trade Restrictions.
A system of flexible exchange rates does not require the introduction of
complicated and expansive trade restrictions and exchange controls. Thus
the cost of foreign exchange restrictions is removed.
xi. No Need of Forming Custom Unions and Currency Areas
Under this system, the world can get rid of competitive exchange rate
depreciation and tariff warfare among nations and there shall be no need of
forming custom unions and currency areas which are the concomitant results
of the system of fixed exchange rates.
xii. Economical
This system is very economical because it does not require idle holding of
foreign currencies. Rather, a country can use its foreign reserves to meet its
immediate requirements.
xiii. Promotes International trade
This system promotes international trade because it maintains the exchange

rates at their natural level through continuous market adjustments. Thus there
is no danger of over-valuation or under-valuation of a country’s currency.
xiv. Insulation from International Economic Events
Under this system, a country is protected against international economic

fluctuations and shocks by making adjustments in its exchange rates.
xv. Comparative Advantage
Under this system, the exchange rates are always in equilibrium. It is, therefore,
possible to assess the comparative advantage of a country in a particular
commodity.
11.3.3 CASE AGAINST FLEXIBLE EXCHANGE RATES

The advocates of fixed exchange rates advance the following arguments
against a system of flexible exchange rates.
i. Mal-allocation of Resources
Critics of flexible exchange rates point out that market mechanism may fail to
bring about an appropriate exchange rate. The equilibrium exchange rate in
the foreign exchange market at a point of time may not give correct signals to
concerned parties in the country. This may lead to wrong decisions and mal-
allocation of resources with the country.
ii. Official Intervention
It is difficult to define a freely flexible exchange rate. It is not possible to have

an exchange rate where there is absolutely no official intervention. Government
may not intervene directly in the foreign exchange market, but domestic
monetary and fiscal measures do influence foreign exchange rates. For
instance, if domestic saving is more than domestic investment, it means that
the country is a net investor abroad. The outflow of capital will bring down the
exchange rate. All this may be due to the indirect impact of government policies.
Further, in the absence of any understanding among governments about
exchange rate manipulation, the system of flexible exchange rates might lapse
into anarchy, for every country would try to establish favourable exchange
rates with other countries. This may lead to retaliation among nations and
result in war of exchange rates with disruptive effects on trade and capital
movements. Thus some sort of understanding or agreement concerning
exchange rates is implied in a regime of flexible exchange rates.
iii. No Justification
As a corollary, there is no justification for a government to leave the

determination of exchange rates to international market forces when prices,
rents, wages, interest rates, etc. are often controlled by the government.
iv. Exchange Risks and Uncertainty
Another disadvantage of this system is that frequent variations in exchange

rates, create exchange risks, breed uncertainty and impede international trade
and capital movements. For instance, an Indian who imports from Japan and
promises to pay in yen runs the risk that the rupee price of yen will rise above
expected levels. And the Japanese exporter who sells for rupees runs the risk
that the yen price of rupees will fall below expected levels. Similarly, exchange
risks may be even more serious for long-term capital movements. This is
because under a system of flexible exchange rates borrowers and lenders
will be discouraged to enter into long-term contacts and the possibility of varying
burden for servicing and repayment may be prohibitive.
BO Sodersten has shown how flexible exchange rates increase uncertainty

for traders and have a dampening effect on the volume of foreign trade. Assume
that a country is under a regime of flexible exchange rates, the general price
level is stable and the balance of trade is in equilibrium. Suppose the demand
for the country’s exports decreases, this leads to depreciation of the country’s
currency which, in turn, raises import prices and brings a fall in imports.
Consequently, importers will be adversely affected. At the same time, exporters
will gain with the increase in the prices of export goods. But the volume of
exports will decline whereby they will also be losers. Opposite will be the
consequences when currency appreciates. Suppose there is an abnormal
inflow of short-term, increase the cost of A’s exports in terms of foreign

currencies, thereby lowering the levels of output, employment and income in
its export industries. The rise of exchange rate will also lower the cost of
imports, thus discouraging output and employment in A’s import competing
industries. Thus importers and exporters will be at a disadvantage and the
volume of trade will decline.
Fig.No. 3 Exchange Risks and Uncertainty
This is illustrated in terms of Sodersten’s diagram, shown as Figure 3. The

horizontal line S shows stable or fixed exchange ate, and the zig-zag line F
shows flexible exchange rate. At time t0 the exchange rate is the same E,
under both flexible and fixed rate systems, At t1 the currency depreciates and
the flexible exchange rate moves to D while the fixed exchange rate is at the
same level D1 (=E). Since import prices have rise, imports will be discouraged
and exports will be encouraged. At time t2 the currency appreciates and the
flexible rate moves to A whereas the fixed rate remains at the same level A1
(=E). At A import prices fall. Imports are encouraged and exports are
discouraged. So exports will be at disadvantage at A that at A1 and importers
will gain at A than at A1. Similar will be at time t3 with fixed exchange rate at C1
and the flexible exchange rate at C level. Thus fluctuations of the exchange
rate around a trend value will increase risks for exports and imports that will
adversely effect the volume of foreign trade.
v. Adverse Effect of Speculation
Under this system, speculation adversely influences fluctuations in supply

and demand for foreign exchange. Critics argue on the basis of empirical
evidence that speculation is destabilizing which means that it aggravates

fluctuations in exchange rate. “It is often said that speculators see a decline in
the exchange rate as a signal for further decline, and that their actions will
cause the movement in the exchange rate to be larger than it would be in the
absence of speculation. In such a case, speculation is destabilizing. Sodersten
points out the “the limited experience from the 1920s seem to show that
speculation at the time destabilishing. Since floating rates became common
in 1973, fluctuations in exchange rates have been large. It seem that some of
the excessive fluctuations have been caused by destabilishing speculation”.
Such fluctuations increase uncertainties in trade and reduce the volume of
foreign trade further.
vi. Encouragement to Inflation
This systems has inflationary bias. Critics argue that under a system of flexible
exchange rates, a depreciation of the exchange rate leads to a vicious circle
of inflation. Depreciation leads to a rise in import prices thereby making import
goods more expensive. This leads to cost-push inflation. At the same time,
export prices rise. Consequently, with the rise in the cost of living, money
wages rise which, in turn, intensify inflation. But an appreciation of currency is
unlikely to lead to a reduction in wages and prices when imports prices fall.
This is because wages and prices are sticky downwards. This leads to an
asymmetry which produces that Triffin calls ratchet effect that imparts an
inflationary bias to the economy.
vii. Breaks the World Market
This system breaks up the world market. There is no one money which serves
as a medium of exchange, unit of account, store of value and a standard of
deferred payment. Under it, the world market for goods and capital would be
divided. Resources allocation would be vastly sub-optimal. In fact, such a
system clearly would not last long, according to Kindleberger.
viii. Failure to Solve Balance of Payments Deficit of LDCs
LDCs are faced with the perpetual problem of deficit in their balance of
payments because they import raw materials, machinery, capital equipments,
etc. for their development. But their exports are limited to primary and other
products which fetch low prices in world markets. Their balance of payments
deficit can be removed in a system of flexible exchange rates if there is
continuous depreciation of the country’s currency.
Fig.No.4 Failure to Solve Balance of Payments Deficit of LDCs
This is illustrated in Fig.4 where D is the country’s demand curve for foreign
exchange and S is the supply curve of foreign exchange. To begin, P is the
point where OE exchange rate is determined. Suppose disequilibrium develops
in the balance of payments of the LDC in relation to the dollar currency area.
This is shown by the shift in the demand curve from D to D1 and the deficit
equals PP’. This means an increase in the demand for pounds and depreciation
of the currency (say, Rupee) of the LDC. Now the exchange rate of Rs. – £
rises to OE1. This process of depreciation of the LDC currency continues
with the rise in the exchange rate to OE2 and so on. Such a policy of continuous
depreciation adversely affects trade and development process in LDCs.
CHECK YOUR PROGRESS
A. State whether the following statements are True or False
1. Rate of exchange means the external value of country’s currency.

2. Fixed exchange rate means the rate of foreign exchange remain
unchanged over a period.
3. Under the flexible exchange rate system rates are determined by market
forces.
SUMMARY
Fixed or pegged exchange rates all exchange transactions take place at an

exchange rate that is determined by the monetary authority. A country would
benefit if it has a fixed value of its currency in relation to other countries. There
is no uncertainty and risk resulting form a regime of fixed exchange rate. Fixed
exchange rate is best for small countries. A system of flexible exchange rates
is simple in the operative mechanism. Under the Flexible exchange rates
autonomy of the domestic economic policies is preserved.
GLOSSARY
Floating exchange rate : The foreign exchange system in which currencies

are allowed to fluctuate with international market forces.
Exchange rate : The rate at which central banks will exchange one country’s
currency for another.
1. True 2. True 3. True
MODEL QUESTIONS
1. What is rate of exchange? How is it determined?

2. Explain the case for and against floating exchange rate?
3. Give arguments for and against a system of fixed exchange rates?
BOOKS FOR REFERENCE
1. M.L.Jhingan – International Economics

2. D.M. Mithani – International Economics
3. Francis Cherunilam.
UNIT 12
EXCHANGE CONTROL
STRUCTURE
Overview
Learning Objectives
12.1 Exchange Control
121.1 Meaning of Exchange control
121.2 Objectives of Exchange control
12.1.3 Methods of Exchange Control
12.1.4 Merits and Defects of Exchange control
Summary
Glossary
Model Questions
Books for reference
OVERVIEW
In this unit 13 you are going to learn the meaning of exchange control and the
objectives of Exchange control. It further explains the methods of Exchange
control. It also focuses upon Merits of Exchange control and the defects of
Exchange control.
LEARNING OBJECTIVES
Ø explain the meaning of Exchange control

Ø describe the objectives of Exchange control
Ø list out the methods of Exchange control
Ø discuss the merits of Exchange control
Ø state the Demerits of Exchange control
12.1 EXCHANGE CONTROL
121.1 MEANING OF EXCHANGE CONTROL

It is process by which the government centralises all foreign exchange
operations within its purview through the central bank of the country and
152 Exchange Control
administers regulations pertaining to it, so that the foreign exchange resources

will be utilised carefully on the basis of priorities.
12.1.2 OBJECTIVES OF EXCHANGE CONTROL

i. When the Government feels that the normal mechanism of free foreign
exchange market may not be desirable or effective.
ii. When there is a heavy run on the country’s foreign exchange reserve,
due to heavy adverse balance of payments or due to outflow of capital
on a large scale;
iii. When the government wants to and thereby bring about economic
development of the country,
iv. When the government wants to secure adequate foreign exchange in
order to buy essential goods from abroad;
v. When the government of a country wants to avoid fluctuations and
maintain stable exchange rate, exchange control will be adopted.
vi. Exchange control is essential in a planned economy in which all
economic activities of the country are controlled by the government.
vii. Finally, when the government wants to freeze the assets of the
foreigners, particularly in times of war and prevent them from helping
their own countries, exchange control in full measure will be adopted.
12.1.3 METHODS OF EXCHANGE CONTROL
The methods adopted can be classified under (1) Direct methods : and (2)
Indirect methods.
i. Intervention
Intervention refers to the control in which all foreign exchange transactions

are centralised with the government, either through the Central Bank of the
country or any government agency authorised for this purpose. All receipts of
foreign exchange will have to be surrendered to this central authority for local
currency. All those who have to make payments to foreigners will have to buy
‘foreign exchange’ from the central authority. In other words, there will be no
private holding of foreign currency or selling or buying of foreign currency.
This method will enable the government to centralise the entire demand and
supply of foreign exchange resources, so that it may prudently adjust the one
with the other and utilise the scarce foreign exchange in a judicious manner.
The foreign exchange is rationed among the licensed importers for the import
of very essential and indispensable goods needed for the country, for
sustenance and development.
Exchange Pegging
Intervention may also take the form of exchange pegging which means the
government intervenes the foreign exchange market either to hold the value of
the currency up or to hold it down. When the government fixes the rate of
exchange above the normal rate, it is known as Pegging Up. On the other
hand, if the government fixes the exchange rate below the normal market
rate, it is known as Pegging Down. This method is generally and usually adopted
during war times when there will be violent fluctuations, in the exchange rate
of the currency. It is to check these fluctuations that the government adopts
the policy of exchange pegging. It is well known that during the war time, every
country will face the problem of inflation lowering value of the currency. In
order to arrest the depreciating trend in the value of the currency, the government
may adopt exchange pegging. Pegging down operation may also be resorted
to in order to maintain the currency in fixed under valuation. Pegging up and
pegging down are typical examples of intervention by the government in order
to exercise exchange control. The policy of intervention aims at neutralizing
the forces of demand and supply of foreign exchange resources. When this
method is adopted, it has to be continued indefinitely and if it fails due to some
reason or other, it has to be augmented by other direct methods.
ii. Restriction
Restriction is a more powerful and effective method of exchange control than

intervention. Restriction refers tot he policy of the government to prevent the
existing supply of and demand for its currency from reaching the foreign
exchange market. In fact, restriction is the exchange control proper. The
‘restriction’ may take three forms.
(a) All foreign exchange dealings are centralised with the central bank of the
country. (b) The national currency may not be offered without the previous
permission of the government. (c) All foreign exchange transactions should
be made only through the agency of the government and any private dealings
in foreign exchange will become illegal. The usual procedure, as indicated
already, is to order all exporters to surrender their foreign exchange to the

Central authority and to ration this foreign exchange among licensed importers.
Exchange control of this type involves import control also.
iii. Clearing Agreement

A country, instead of adopting exchange control on ‘unilateral’ basis, may do
so on ‘bilateral’ basis with an agreement along with another foreign country.
This is called clearing agreement. According to this agreement, the importers
in each country pay to their respective central banks the amount payable by
them for their imports. The money so collected by the central bank is used to
pay on the exporters of each country. The rate of exchange between the two
countries if fixed by the terms of agreement.
For illustration, let us suppose that India and England enter into clearing
agreement. The Reserve Bank of India will open an account in its books in the
name of Bank of England; while the Bank of England will open an account in
the name of Reserve Bank of India. The Indian importers of goods from England
pay in rupees to the credit of Bank of England. All Indian exporters of goods to
England will receive payments from the Reserve Bank of India out of this
account. Similarly, the Bank of England will receive in the name of Reserve
Bank of India’s account from English importers of goods from India and pay
the same money out of this account to the English exporters of goods to India.
This system will regulate imports on both sides and ensure stability in foreign
exchange by avoiding fluctuations in the rate of exchange. This kind of clearing
agreement will tend to encourage bilateral agreements at the cost of multilateral
trade in the international level. But, it has the merit of discouraging dumping
and currency depreciation.
iv. Standstill Agreement
Under this method, the movement of capital between two countries is checked
through a moratorium on outstanding short-term foreign debts, especially inter-
bank debts. This device was adopted first by Germany after the Great
Depression, when the German banks could not pay their short term debts to
foreign banks due to the non-availability of foreign exchange. Under this system,
the short term debts are either converted into long term debts or payments
made in a very graduated manner. Under the standstill agreement, the debtor
country will be given adequate time to improve its position.
v. Transfer Moratoria
Under this method, the payment for imported goods or the interest on foreign
capital is not made immediately, but after the lapse of certain period which will
be predetermined by means of agreement between the two countries. The
importers, as well as the debtors’ deposit the amount (which they owe to
foreigners) in domestic currency in some authorised bank. After the fixed period
is over, the bank makes the payments to the foreign exporters and creditors in
foreign currency. The object is to afford adequate time for the country in
difficulties to set right its foreign exchange problems.
12.1.4 MERITS AND DEFECTS OF EXCHANGE CONTROL

1. Exchange control is very indispensable for the country, particularly
during the period of war. During the war period, the country may have
to import arms and ammunitions and other war materials on a very
large scale. This may turn the rte of exchange of the currency of the
country very adverse. Hence, exchange control is very essential to
check this possibility.
2. Exchange control is also essential for a country on the way of economic
development. Countries on the course of economic development
require large scale imports of machines, raw materials, finished and
semi-finished goods and also technicians. This will result in the decline
of the value of the currency and to check this trend, the country should
exercise all methods of exchange control in order to import essential
items for purposes of development.
3. Exchange control is useful in controlling the large scale movement of
hot money amongst the countries of the world. The large scale
movement of hot money creates several complications for the smooth
functioning of the economy. Sudden flight of capital from a country
may disrupt the economy. Exchange control is essential for maintaining
stability and smooth functioning of economy.
4. This enables the country to correct adverse balance of payments, adopt
independent economic policy and arrest violent fluctuations in the
foreign exchange rate and also avoid depressionary trend.
5. Economic planning, development of domestic industries, self-

sufficiency in production, channelisation of foreign trade in the desired
manner and debt-servicing etc. would be possible only through
exercising effective exchange control.
CHECK YOUR PROGRESS
1. Exchange control is a protective device

2. Economic nationalism is the ill effect of exchange control
3. Intervention means that a government may intervene in the foreign
exchange market to hold the value of its currency up or to hold it down.
4. Exchange control is a process by which the Govt. centralizes all foreign
exchange operations within its purview through the central bank of the country.
SUMMARY
Exchange control means that all foreign receipts and payments in the form of
foreign currencies are controlled by the government the objectives of the
exchange control are (1) to stabilize the exchange rate (2) to keep their
currencies undervalued (3) to keep their currencies undervalued (4) to prevent
the flight of capitals from the country (5) to give protection to domestic industries
against foreign producers (6) to check non-essential imports (7) to earn and
conserve foreign exchange. There are 2 methods of exchange control - one is
direct and the other is indirect.
GLOSSARY
Multiple exchange rates : The system of fixing different Exchange rates for
nations currency according to the purposes for which it is required.
Blocked Account : A bank account of foreigner the operation of which is denied

to him through a government device.
1. True 2. True 3. True 4. True

MODEL QUESTIONS
1. Bring out the objectives of exchange control?

2. Briefly discuss the various methods of exchange control?
3. State the merits and demerits of exchange control?
BOOKS FOR REFERENCE

158 IMF in India
BLOCK - V
INTERNATIONAL FINANCIAL INSTITUTIONS AND TRADE

AGREEMENTS
Unit 13 : IMF in India
Unit 14 : World Bank and India

Unit 15 : GATT and WTO
UNIT 13
IMF IN INDIA
STRUCTURE
Overview
Learning Objectives
13.1 International Monetary Fund
13.1.1 Objectives of the Fund
13.1.2 Organisation
13.1.3 Working of the fund
13.1.4 India & IMF
13.1.5 Meaning of Problem of International liquidity
13.1.6 Origin of SDR and uses of SDR
Summary
Glossary
Model Questions
Books for reference
OVERVIEW
In this unit - 14 you are going to learn the objectives of the fund and working of
the fund. It explains the role of IMF in India. It also further explains the meaning
of Problem of International liquidity .uses of SDR is also explained in this unit.
LEARNING OBJECTIVES
Ø explain the objectives of the fund

Ø describe the working of the fund
Ø discuss the role of IMF in India
Ø list out the problems of International liquidity
Ø bring out the uses of SDR
13.1 INTERNATIONAL MONETARY FUND
The International Monetary Fund (IMF) was established on 27th December,

1945. However, the IMF started functioning with effect from 1st March, 1997.
160 IMF in India
The IMF started with the initial membership of 30 countries, One June, 1991
its membership rose to 155, Communist countries like China and Russia
kept themselves away from its membership. However, in April, 1980 China
became the member of the IMF Afterwards in 1992 Russia along with other
communist countries became the member of IMF Thus, at the end of 1999
the membership of IMF rose to 182 as countries. In the words of G.N.Halm,
“The International Monetary Fund is a bank of central banks and the capstone
in the world’s monetary system”.
13.1.1 OBJECTIVES OF THE FUND

(i) International Monetary Cooperation
The most important objective of the Fund was to establish monetary cooperation
amongst the various member countries. As already pointed out above, one of
the major causes of the Second World War was the absence of monetary
cooperation amongst the countries of the world. Hence, it was now considered
necessary to establish international monetary cooperation to prevent the
outbreak of war in future.
(ii) To ensure stability in Foreign Exchange Rates
As already said above, there used to be a good deal of instability in foreign

exchange rates before the Second World War. This instability of foreign
exchange rates had produced adverse repercussions on international trade.
Hence, the IMF was established to eliminate this instability of foreign exchange.
(iii) To Eliminate Exchange Control
Before the Second World War, almost every country had resorted to exchange
control as a device to fix its exchange rate at a particular level. This produced
adverse effects on international trade. Hence, it was now considered necessary
to remove or relax these exchange controls with a view to giving
encouragement to the flow of international trade.
(iv) To establish a system of multilateral trade and payments system
Another objective of the IMF was to establish a multilateral trade and payments
system in place of the old bilateral trade agreements, because the latter
obstructed the free flow of international trade.
(v) To Promote International Trade
Still another objective of the IMF was to promote international trade by removing,
all obstacles which had the effect of restricting it.
(vi) To help Member Nations to Achieve Balanced Economic Growth of

International Trade
The IMF helps the member nations, particularly the backward nations, to achieve
balanced economic growth. To attain this objective, it helps the member nations
to secure a rising level of employment.
(vii) To Eliminate or to Reduce the Disequilibrium in the Balance of

payments
The IMF helps the member nations eliminate or reduce the disequilibrium in
their balance of payments. To achieve this objective, it sells or lends foreign
currencies to the member nations.
(viii) To Promote Investment of Capital in Backward and

Underdeveloped Countries
The IMF helps promote the export of capital from the richer to the poorer
countries so that the latter could develop their economic resources for
achieving higher living standards.
(ix) To Develop confidence amongst Members
Another objective of IMF is to develop and provide confidence amongst the

membership by providing Fund’s resources available to them under adequate
safeguards, thus providing them with opportunity to correct mal-adjustments
in their balance of payments position without resorting measures destructive
of national or international prosperity.
(x) To shorten the duration and reduce the degree of disequilibrium in the
international balance of payments of members.
13.1.2 ORGANISATION
There are two bodies to run the management of the IMF – (1) The Board of
Governors, and (2) The Board of Directors. Every member country appoints
one Governor to participate in the meetings of the Board of Governors. Every
member country has the right to appoint an alternate Governor who participates
162 IMF in India
in the meetings of the Board in the absence of the Governor. The Board of
Governors formulates the general policy of the IMF, but to carry on the day-to-
day working of the IMF, there is another body known as the Board of Directors.
There are 21 members in the Board of Directors. Seven of them are permanent
members, while fourteen are elected from amongst the remaining members
at intervals of two years by the remaining members according to the
constituencies on a roughly geographical basis. There is a Managing Director
of the Fund who is elected by the Executive Directors. He is usually a politician
or an important international official. He is non-voting chairman of the Executive
Board. Besides acting as the Chairman of the Executive Board, the Managing
Director is the head of the fund staff is fully responsible for its organization,
appointment and dismissal. The Executive Board or the Board of Governors
is the most powerful organ of the Fund and exercises wide powers.
The permanent members are the U.S.A., the U.K., France, Germany, Japan,
Italy and Canada. If any country violates the Rules and Regulations of the IMF its
membership can be ended by the Fund. It takes decisions on important issues,
such as, revision of quotas, entry of new members, election of directors and the
determination of the par values of the currencies of member nations. The board
of Directors of the IMF holds its meetings at its office located in Washington.
Further, there is an Interim Committee which was established in October,

1974 to advise the Board of Governors on supervising and controlling
management and adaptation of the International Monetary System in order to
avoid disturbances that might threaten it. It currently has 22 members.
Besides the above, there is also a Development Committee which was also
established in 1974. It also consists of 22 members. It advises and reports to
the Board of Governors on all aspects of the transfer of the real resources to
developing countries like India and makes suggestions for their implementation.
Criteria became the 179th member of the IMF on July 26, 1994. The addition to
Fund membership came after more than a year when Micronesia became the
178th member on June 24, 1993. The total Fund quota as of July 31, 1994
stood at SDR 144 billion.
According to the Fund Agreement, the headquarters of the Fund are located in
a country which happens to have the highest quota of capital of the IMF The
head office of the IMF is at present located in Washington. But the IMF has
discretion to open its branches in other countries as well. According to the
Articles of Agreement, 50 per cent of the gold stock of the IMF is kept in the
country with the highest quota of capital which happens to be the U.S.A. at the
present moment.
131.3 WORKING OF THE FUND

There are three important functions of the Fund. They are as follows:
1. The fund helps the member countries to eliminate or at least to minimize

the short period disequilibrium in their balance of payments. The Fund
does this either by selling or by lending foreign currencies to the
members concerned.
2. The Fund also helps the member countries to remove the long-period
disequilibrium in the balance of payments. If there are fundamental
changes in the economies of the member countries, the Fund can
advise them to effect changes in the par values of their currencies.
3. The Fund tenders advice to the member countries on economic and
monetary matters, because it is in a position to do so in view of its
special status. Thus, the Fund helps the member countries to stablise
their economies.
Technical Assistance by the IMF
Along with financial help, the Fund also grants technical assistance to the
member countries. The technical assistance is given in two ways. Firstly, the
Fund grants to the member countries the services of its specialists and experts.
These specialists and experts render valuable help to the member countries
in solving their complicated economic and monetary problems. In fact, these
experts of the Fund have helped the underdeveloped countries in the
formulation of their monetary, fiscal and exchange policies. Secondly, the Fund
also sometimes sends to the member countries outside experts, i.e. those
experts who are not in the service of the Fund.
Recently, the Fund has set up two new departments, namely, (i) the Central
Banking Services Department, and (ii) the Fiscal Affairs Department. The first
department gives to the member countries the services of its specialists to
run and manage their Central Banks. The second department tenders useful
164 IMF in India
advice to the member countries on fiscal affairs. The Fund has also initiated
several schemes to give practical training to the officers of the member
countries in such subjects an monetary and economic management.
13.1.4 INDIA & IMF

India is a founder-member of the Fund and has been one of the largest
subscribers till a few years ago. India’s original subscription quota was SDRs
400 million. The present subscription quota is about SDRs 2,200 million of
which SDRs 550 million consist of gold and dollar. The initial par value
established by India with the Fund in 1946 was Rs.3.30 per U.S. dollar; the par
value was changed to Rs.4.76 in 1949 to Rs.7.50 in 1966, and Rs.8.25 in
June 1978. Since then the external value of the rupee has been allowed to
fluctuate according to market conditions of demand and supply (the present
value is Rs.35 to a dollar).
IMF has assisted India many times. In order to meet the balance of payments
deficits, India borrowed $100 million from the Fund during 1948-49 which was
paid back by 1956-57. In 1957, India entered into an agreement with the Fund
for $ 200 million to meet its temporary balance of payments difficulties arising
out of its development programmes. India arranged for another drawing to the
tune of $ 250 million in 1961 from the IMF This assistance had been invaluable
to India which had dangerously low level of foreign exchange reserves. In
1980-81, India’s balance of payments position had become highly critical and
the IMF agreed to grant a credit of SDRs 5000 million (or 5 billion) under
Extended Fund Facility. This was the single largest loan made by IMF to a
member-country. India managed the facility admirably and used only SDRs
3.9 million and surrendered the balance to IMF The Fund (along with the World
Bank) has played a significant role in the formation and implementation of the
new liberal economic policy in India and the consequent structural changes.
13.1.5 MEANING OF PROBLEM OF INTERNATIONAL LIQUIDITY

The problem of international liquidity is not a new one. It existed even during the
days of the Gold Standard. Some countries under the Gold Standard did not
possess adequate gold reserves to meet the deficit in their balance of payments.
In fact, the inadequacy of internal liquidity was an important cause of the downfall
of the Gold Standard in the mid-thirties. Since 1958, there has been a good deal
of concern amongst the member countries of the Fund about the worsening
international liquidity situation in the world. In fact, the problem of international
liquidity had become pretty serious during the last few years.
The term ‘International Liquidity’ comprises all those financial resources and
facilities which are available to monetary authorities of member countries for
financing the deficits in their international balance of payments. The various
components of international liquidity are : (i) Gold held by the Central Banks
(gold held by private individuals is not included), (ii) Foreign currencies (such
as Pound Sterling, U.S. Dollars, D.Marks, Swiss Francs etc.) held by the Central
Banks, (iii) Borrowing facilities available from “the IMF under different schemes,
(iv) Credit facilities available under ‘Swap’ and other related credit arrangement,
(v) Special Drawing Rights (SDRs), and (vi) A country’s borrowing capacity in
the international money market. The term ‘International Liquidity’ excludes
private foreign exchange holdings, banks and trade credits used to finance
international trade transaction, government credit supplied for export purpose
by institutions, such as, Import-Export Bank, long-term International Financing,
through international organizations, such as the World Bank, International
Financial Corporation, International Development Association. The present
inadequacy of international liquidity stands confirmed by the increasing balance
of payments difficulties of individual members countries. The means of
international payment, such as, gold and acceptable foreign exchange reserves
have not grown at a rate fast enough to meet the growing demand for them for
payments purposes. The world stock of gold and exchange reserves has
grown at a very slow rate since 1964. In fact, the total world gold reserves
have actually declined from SDR 41.9 billion in 1965 to SDR 36.1 billion in
1971, while the volume of international credit transactions has been growing
rapidly over the years. The pressure of demand and the decline in international
monetary reserves has been increasing with such rapidity that even the leading
member countries have been frequently compelled to devalue their currencies.
The pressure on the balance of payments had been so great that the once
mighty U.S. Dollar had been devalued twice within a period of less than 14
months after December 1971.
The fact of the matter is that world liquidity has not grown as fast as world
trade in recent years. Though there is a global shortage of liquidity at the
166 IMF in India
moment, it does not imply that all countries are confronted with the problem of
scarce liquidity. There are some countries like West Germany, Switzerland
and Japan which may be referred to as “liquidity surplus pockets” in a world
where an overwhelming majority of the countries are faced with an acute
shortage of liquidity. At least, majority of the developing countries of Asia and
Africa constitute what may be called “liquidity deficit pockets” of the world.
Hence the problem is not only one of increasing the quantity of international
liquidity, but also one of proper and equitable distribution of this liquidity among
the developing and developed countries of the world. From the qualitative point
of view, the problem at the present moment is that the foreign exchange
reserves held by various countries are generally in the form of two major
currencies, namely, Pound Sterling and the U.S. Dollar. Both the currencies,
particularly the U.S. Dollar, have been under severe strains during the past
decade or so. The U.S. Government even suspended the convertibility of the
Dollar into gold for foreign Central Banks and treasuries. More and more
countries are now abandoning their link with the U.S. Dollar and converting
their exchange reserves into other strong and stable currencies, such as, the
German D. Mark, the Japanese Yen and the Swiss Francs. Even the OPEC
countries are now hesitant to accept payments for their oil exports in terms of
the U.S. Dollar. The quantitative aspect of the world liquidity problem is, however,
more important than the qualitative aspect. Several proposals had been made
in the past to improve the world liquidity situation.
(i) Robert Triffen’s Plan
In 1958, Prof. Robert Triffen presented his plan to solve the problem of world
liquidity. According to this plan, the IMF was to become the World Central
Bank. The member countries could deposit local currencies in this Bank in
exchange for foreign currencies required by them. The member countries
were also required to transfer their foreign exchange reserves to this Bank,
which would then act as clearing house for setting off the claims and counter-
claims of these countries. The plan fell through because none of the countries
was prepared to surrender its foreign exchange reserves to the proposed
World Central Bank.
(ii) Bernstein’s Plan
In 1961, Prof. Bernstein, Executive Director of the IMF suggested that the IMF
should float debentures which should be subscribed by the rich, industrialized
countries like the U.S.A., the U.K., France, West Germany, Canada and Japan;
and the fund so raised should be utilised to advance loans to countries
confronted with balance of payments difficulties. This plan was later on
accepted by the IMF in 1961 and implemented in 1961. This came to be known
as the IMF Borrowing Scheme. The IMF raised 6 billion Dollars in ten currencies
under this scheme. But this scheme failed to solve the problem of world liquidity
in its entirety.
(iii) Raising the Official Price of Gold
This proposal was made by the late President Charles de Gaulle of France
who believe that raising the official price of gold (fixed at 35 U.S. Dollars per
ounce of gold by the IMF) would solve the problem of world liquidity in its
entirety. There was, no doubt, that raising the official price of gold would increase
the volume of liquidity in the world. But it would benefit only three countries like
France, South Africa, and U.S.S.R. which happened to have large stocks of
gold with them. The distribution of world liquidity among different countries
would become more unequal and inequitable than before. Nevertheless, the
official price of gold was raised from 35 U.S. Dollars per ounce to 38 U.S.
Dollars in December 1971 and again to 42.2 Dollars in February 1973. This
step did result in increasing the value of gold stocks lying with member countries
to some extent. Despite these efforts made in the past, the problem of world
liquidity still defies solution.
Conditional and Unconditional liquidity
The IMF is an international institution which deals in liquidity. The fund provides
international liquidity to its members from time to time under different schemes
to enable them to meet the deficit in their balance of payments. It provides to
its members two kinds of liquidities. The first kind of liquidity consists of the
members’ drawing rights in the gold tranche – known as “unconditional liquidity”.
The unconditional liquidity is treated by the members like any other reserve.
The member concerned can borrow in the gold tranche without any conditions
being attached to the loan by the Fund. In other words, liquidity with the gold
168 IMF in India
tranche position is made available to all the members automatically and

unconditionally by the Fund. The second kind of liquidity provided by the Fund
to its member countries consists of the drawing right of the members in the
credit tranche – often referred to as “conditional liquidity”. The drawing rights
with the credit tranche cannot be allowed by the Fund without applying the
performance test. In other worlds the amount to be drawn member country
under the credit tranche is subject to the fulfillment of certain conditions
imposed by the Fund.
The extent of unconditional liquidity provided by the Fund is small relatively to

the conditional liquidity. At present, the Fund’s unconditional liquidity supply
capacity is over SDR 6 billion while the supply of conditional liquidity is more
than 16 billion. The supply of unconditional as well as conditional liquidity has
been growing year after year consequent upon the increases in the quotas of
member countries.
Standby Credit Scheme
The Fund also provides financial assistance to the member countries in the
form of standby credit. This form of facility was created in 1952. This was
intended for those member countries which did not need the immediate use
of Fund’s resources but felt that they might need financial help from the Fund
in the near future. The amount of financial assistance provided by the Fund
under the standby credit system has been quite substantial during the past
few years.
G.A.B. Scheme
The Fund also provides liquidity to its members under another scheme known
as the General Arrangements of Borrow (GAB) Scheme which was started in
December 1964, for a period of four years. But the scheme continued even
after the expiry of the four-year term. The scheme authorizes the Fund to
borrow up to SDR 6 billion the currencies of ten major industrial countries in
case the Fund was confronted with a major foreign exchange crisis. The U.K.
was granted a loan of 3.9 billion Dollars in December 1976, under this scheme
to meet her foreign exchange crisis. The Interim committee of the IMF decided
in its meeting help on 10-11 February 1983 to triple this supplemental
emergency fund which the ten largest members of the Fund had hitherto
maintained for their own use. This increased the G.A.B. Fund from the current
6 billion SDR to 17 billion SDR. The Fund would now be used to make loans to
any IMF member (including the developing countries) in serious financial
trouble. (Hitherto the G.A.G. Fund was used only for the benefit of the ten large
industrial countries). The willingness of the Group of Ten to extend emergency
credit to all the IMF members persuaded Saudi Arabia to contribute SDR 1.5
billion to the emergency G.A.B. Fund.
Special Oil Facility
A scheme known as the Special Oil Facility was devised by the IMF in June
1974 to advance loans to the non-oil developing countries to enable them to
meet their deficit arising out of oil imports from the OPEC countries. The
Facility was set up by the IMF with SDR 2.5 billion as the initial amount.
Contributions to this fund were made by the OPEC as well as some developed
countries of the world. Loans out of this Fund were made to non-oil developing
countries for a period ranging from 3 to 7 years at a rate of interest varying
between 6 and 7 per cent per annum primarily for meeting the deficit arising
out of oil imports. The Facility proved extremely useful to those non-oil
developing countries hit hard by the rising oil prices. But unfortunately it was
ended by the IMF in March 1976, despite protests from developing countries.
Subsidy Account
A subsidy account was established by the Fund in August 1975, to assist the
Most Seriously Affected (MSA members to meet the cost of using resources
made available through the Oil Facility for 1975. Contributions to the Account
were solicited from all members including oil-exporting and industrial countries.
Contributions actually received till end April 1978, amounted to SDR 101 million.
The Executive Directors decided that the rate of subsidy would be 5 per cent
for the fiscal year ending April 1977, same as the preceding year, reducing the
effective cost of using the 1975 Oil Facility for MSA countries from 7.71 to 2.17
per cent. The subsidy aggregating SDR 27.5 million was received by 18
countries during the year ending April 1978 with India receiving SDR 16 million.
Compensatory Financing of Export Fluctuations Scheme
There is still another scheme known as the Compensatory Financing Export

Fluctuations Scheme. Under this scheme the Fund provides borrowing
170 IMF in India
facilities to member countries above their ordinary draw rights to finance their
balance of payment deficits resulting from the shortfall in export earnings
beyond their control. This scheme was introduced in 1963. Under this scheme,
member country suffering from deficit in balance of payments due to
fluctuations in the export receipts could apply to the Fund additional borrowing
facilities which could exceed 25 per cent of its quota in the Fund. Later on, as
a result of an amendment made September 1966, the limit on this purchase
raised from 25 to 50 per cent of the borrow member’s quota.
Mainly, as a result of the liberalization effected in December 1975, and the

decline commodity prices that accompanied to unusually severe recession in
1975, members’ of the Compensatory Financing Facility for year ending April
1977, at SDR 1.75 billion was double from the previous year. The UNCTAD
advocated a further extension of the Scheme. The Annual Fund Bank meeting
held in September 1984 the U.S. representative urged to reduce the access
to this facility by member countries and ground that as a result of the 1983
increase in IMF quotas from 62 billion Dollars to Facility now. Drawings from
the Compensative Financing Facility (CFF) increased from 2.6 billion SDR in
1982 to 2.8 billion SDR in 1983.
Supplementary Financing Facility
The Interim Committee of the Fund at its meeting held in April 1977 reviewed
the developments in international liquidity and in the financial resources of the
Fund. In this context, it recognized the urgent need for a supplement of
arrangement of a temporary nature that would enable the IMF to expand its
assistance of members facing payments imbalances in the no several years.
As in the ease of the Oil Facility of the Fund, under the Supplementary Finance
Facility, would recycle a substantial amount resources borrowed from surplus
countries, thus, enlarge sizably the access to condition to credit by countries
with payment imbalance. The Facility was to be made available to members.
The size of the new Facility would be less than SDR 7.75 billion. The assistance
would be a standby nature and would normally be for a period not longer than
one year. The facility became effective in February 1979. Financial assistance
worth 47.1 million SDR was granted to three countries till 30th July 1979.
Trust Fund
A Trust Fund was established in May 1976 to provide special balance of

payments assistance on concessional terms to eligible developing countries.
The major source of the fund was the profit from the sale of a portion of the
Fund’s own gold and any finance that may be available from voluntary
contributions or from loans from the member countries.
Loans from the Trust Fund carried an interest of ½ per cent and were repayable
in ten semi-equal installments beginning 5½ year from the date of disbursement
and to be completed at the end of the tenth year after the date of disbursement.
The IMF Trust Fund, established in May 1976, was wound up on April 30,
1981. The total loan disbursements to the developing countries at the end of
February 1981 amounted to SDR 2,991 million. These disbursements were
made over to periods of two years each on the basis of 1975 quotas of the
member countries. India was the major beneficiary with a loan disbursement
of SDR 529 million.
IMF Aid Plan for Poor Nations
On December 21, 1980, the IMF announced a 1.25 billion Dollar Subsidy Plan
to cut interest cost on loans available to 83 low-income countries plagued by
high oil prices. Another 2.687 billion dollars would become available to poor
countries in 1984 for much easier loans at half per cent interest rates. The
IMF was obliged to deices this plan in response to the increasing pressure
from poor countries to give more aid to them. Under the Plan, a new account
was set up. Money was to be given out of this account to poor nations to save
three percentage points from 10 billion Dollars worth of loans from “Witteven
Facility”. Nearly 21 poor countries had already benefited from this plan.
Enlarged Access Facility
This facility began to evolve around 1978 and formally went into effect in 1981.
This Facility set the amount that the member countries were entitled to borrow
from the IMF pool of world currencies. Originally, the enlarged access
programme permitted a member country to borrow 150 per cent of its quota
each year for three years. However, at the U.S. instance, it was trimmed in
1983 to 102 per cent of quota for each of three years, with 125 per cent in
exceptional cases. This Facility was to be given by the IMF for a period of
172 IMF in India
three years, and was due to be terminated by the end of 1984. At the annual
meeting of the IMF in September 1984, the developing countries argued that
the conditions under which the enlarged access arrangement was initiated
were not at all different from what they were today. The richer countries agreed
to continue the Facility but reduced the ceiling to make it clear that tit was
purely temporary and had to be phased out. As per the latest decision of the
Interim Committee in September 1985 the ceiling was further reduced to 85
per cent a year, effective from January 1, 1985. In other worlds, a member
country could now borrow each year from the IMF under this Facility up to 85
per cent of its quota. The developing countries, however, were not happy with
this arrangement and continued to press for the restoration of the higher ceiling
as it was in the original scheme. As a result of the revised quotas under the
“Eighth General Review of Quotas” and the enlarged G.A.B. Fund’s pool of
currencies increased considerably, enhancing thereby its capacity to provide
balance of payments assistance to member countries.
Structural Adjustment Facility (SAF)
This facility was created by the IMF in 1988 with SDR 2.7 billion of resources
to support adjustment in low-income countries with chronic balance of
payments problems. The funds available under the SAF came mostly from
repayments of loans from the Trust Fund which would continue to be received
up to April 1991.
These resources were, however, inadequate to enable poorest countries to

overcome their increasingly severe payments difficulties and to help them to
carry out fundamental structural reforms in their economies.
Accordingly, in the middle of December 1987, the IMF established another

Facility known as Enhanced Structural Adjustment Facility (ESAF) with some
6 billion SDR of additional loanable resources. Eligible member countries could
receive under the ESAF up to 250 per cent of quota over a 3 year programme
period with provision for up to 350 per cent in exceptional circumstances.
Gross disbursements to low income countries as concessional rates under the

Structural Adjustment Facility (SAF) and Enhanced Structural Adjustment Facility
(ESAF) increased to SDR 1.43 billion in 1994 from SDR 0.9 billion in 1993.
On February 28, 1994, IMF’s renewed and enlarged concessional lending

window, namely ESAF has initiated operations. The renewed facility, which will
have the same terms and conditions as the original ESAF, established in 1987,
seeks to ensure the continuity of concessional lending by the IMF A distinctive
feature of the funding of the ESAF is the much broader from a cross-section of
the IMF including contributions from developing countries than under the original
ESAF. The additional targeted loan of SDR 5.0 billion together with the loan
agreements of SDR 5.1 billion approved to finance ESAF operations would
raise total loan resources under the ESAF Trust to SDR 10.1 billion.
13.1.6 ORIGIN OF SDR AND USES OF SDR

SDRs were created through the First Amendment to the Fund Articles of
Agreement in 1969 following persistent US deficits in balance of payments to
solve the problem of international liquidity. Until December 1971, an SDR was
linked to 0.88867 gram of gold and was equivalent to US one dollar. With the
breakdown of the fixed parity system, after 1973 when the US dollar and other
major currencies were allowed to float, it was decided to stabilize the exchange
value of the SDR. Accordingly, the value of the SDR was calculated each day
on the basis of a basket of 16 most widely used currencies of the member
countries of the Fund. Each country was given a weight in the basket in
accordance with its importance in international trade and financial markets. After
the Second Amendment to the Fund Articles of Agreement in 1978, the SDR
became an international unit of account. To facilitate its valuation, the number of
currencies in the basket is reduced to five in January 1981. They include the US
dollars the German Deutsche Mark, the British Pound, the French Franc and
the Japanese Yen. The present currency composition and weighting pattern of
the SDR is revised every five years beginning January 1, 1986. The revision of
weights is based on the both values of the exports of goods and services and
the balances of their currencies held by other members. On October 1, 1997
the value of one SDR was equal to 1.35610 US dollars.
Uses of SDRs
SDR is an international unit of account which is held in the Fund’s Special

Drawing Account. The quotas of all currencies in the Fund General Account
are also valued in terms of the SDR. As the international monetary asset, the
SDR is held in international reserves of Central Banks and Governments to
174 IMF in India
finance their deficits or surpluses of balance of payments. All transactions by

the Fund in the form of loans and their repayments, its liquid reserves, its
capital, etc. are expressed in the SDR.
SDRs are used as a means of payment by Fund members to meet balance

of payments deficits and their total reserve position with the Fund. They cannot
be used for any other purpose. Thus SDRs act both as an international unit of
account and a means of payment. There are three principal uses of SDRs.
1. Transactions with Designation
What do you mean by this? If any member country of the IMF faces deficits in
its BOP, requiring foreign currency, it approaches the IMF with an application
for the same. The IMF designates a participating country in the SDR scheme
with strong and favourable balance of payments and reserve position to provide
its currency in exchange of SDR’s to another participant who requires its
currency and who has made an application for accommodation with IMF The
currency that is to be exchanged with SDR’s of the applicant may belong
either to the designated country or / and to some other countries. The lending
countries are permitted to accept SDR’s in this way so long as their holdings
are less than three times their total allocation.
The transfer of SDR’s and the adjustment mechanism between the different
countries may be illustrated with the help of a hypothetical example, Suppose,
there are three countries, namely, India, Germany and Japan and the IMF
creates SDR’s amounting to SDR 1,000 million. It is further supposed that
IMF allocates quotas to India, Germany and Japan as SDR 100 million, SDR
600 million and SDR 300 million respectively.
Now suppose India has a deficit with Germany to the extent of 100 million
marks. It notifies IMF for conversion of its SDR’s holding into the German
mark. The IMF will ask Germany to accept SDR 100 million from India in
exchange of 100 million German marks. As Germany intimates its acceptance,
the transaction will be complete. When the first transaction is complete, the
SDR holdings of India, of course, become zero, while than of Germany rises
to +700, Japan’s holding remaining unchanged at SDR 300 million. It is again
supposed that Germany has a deficit equivalent to SDR 700 million to be paid
in terms of Japanese currency. Germany will notify the IMF of its intention to
convert its SDR holding into Japanese currency yen. The IMF will intimate
Japan of it. As Japan gives its acceptance, an amount equivalent to SDR 700
million will be debited from the German holding and the accumulation of Japan
will rise by 700 million SDR. As the second transaction is complete, the net
result will be zero holdings of SDR for India and Germany and Japan’s holdings
will get accumulated to SDR 1,000 million. These accounting transactions
are detailed below in the Table.
Table
Imaginary Illustration of Adjustment of SDR Account
(in million SDR)
Sl.No. Item India Germany Japan

1. Initial Allocation +100 +600 +300
2. First Transaction -100 +100 …
3. Result of First Transaction 0 +700 +300
4. Second Transaction 0 -700 +700
5. Result of Second Transaction 0 0 +1000
From this illustration, it is clear that the IMF acts like a Clearing House between
the Central Banks of the participating countries and all adjustments in BOP
disequilibrium are effect through book-entries. From this, it is evident that the
amount SDR is recycled between countries in BOP deficits and countries
with BOP surpluses by means of book-entries, as and when the member
countries demand foreign exchange accommodation. On all SDR holdings
kept in the Special Drawing Account, the IMF has to pay interest and it charges
interest at the same rate on all allocations made to participants. The participants
whose holdings exceed their allocation made to participants. The participants
whose holdings exceed their allocation earn net interest. In the case of
participants whose holdings fall short of their allocations, they have to pay net
charges at the current interest rate.
2. Transactions with General Account
Secondly, SDRs are used in all transactions with the General Account of the
Fund. Participants pay charges in SDRs to the General Account for the use of
the Fund resources and also to repurchase their own currency from it.
176 IMF in India
3. Transactions by Agreement
The third use of SDRs is that the Fund allows sales of SDRs for currency by
agreement with another participant.
In order to further widen the uses of SDRs, the Second Amendment
empowered the Fund to lay down uses of SDRs are : (i) in SWAP arrangements,
(ii) in forward operations, (iii) in loans, (iv) in the settlement of financial
objections, (v) as security for the performance of financial obligations, and (vi)
in donations or grants.
The Fund has empowered, besides the World Bank and its associates, some
other agencies like the Bank of International Settlements, the African
Development Bank, the Arab Monetary Fund, Nordic Investment Bank etc. to
acquire and use SDRs in transactions and operations by agreement under
the same terms and conditions, as applicable to the participating nations in
the SDR scheme.
CHECK YOUR PROGRESS
A. State whether the followings statement are True or False.
1. The IMF is setup to function as a short-term credit institution.

2. Extended fund facility is one of the lending schemes of IMF
3. After the establishment of IMF, the Indian Rupee has become
independent.
4. India is one of those six countries which have been given a permanent
place in the Board of Directors of the Fund.
SUMMARY
The most important objective of the fund was to establish monetary cooperation
amongst the various member countries. The IMF was established to eliminate
this instability of Foreign Exchange. Another objective of IMF was to establish
a multilateral trade and payments system. The short period disequilibrium in
their balance of payments (2) to remove long-run equilibrium in their balance
of payment (3) to provide advice to the member countries in economic and
monetary matters India is a founder member of the fund and has been one of
the five largest subscribers till a few years ago. Whenever developing countries
have asked for assistance from the fund to meet their adverse balances, the
fund has generally helped them.
GLOSSARY
SDR : The SDRs or the so-called “Paper Golds” are ‘Simply entries in the
books of accounts of the participant countries in the special drawing account
of the IMF.
IMF : The International Monetary Fund was established in 1945 with the aim to
promote exchange rate stability and to facilitate the expansion and balanced
growth of international trade.
MODEL QUESTIONS
1. Explain the Functions of IMF.

2. Describe the objectives of IMF.
3. Summarise the scope of the IMF.
4. State the benefits of IMF to India.
5. Write a short note on SDR.
BOOKS FOR REFERENCE
1. M.L.Jhingan - International Economics

2. Francis Cherunilam – International Economics
5. Kindleberger - International Economics
178 World Bank and India
UNIT 14
WORLD BANK AND INDIA
STRUCTURE
Overview
Learning Objectives
14.1 World Bank and India
14.1.1 Objectives and Functions of IBRD
14.1.2 Organisation of the World Bank
14.1.3 Lending operations of the World Bank
14.1.4 Role of World Bank in India
14.1.5 Function of International Finance Corporation and Asian
Development Bank
Summary
Glossary
Answer to check your progress
Model Questions
Books for reference
OVERVIEW
In this unit you are going to learn about the objectives of the World Bank and
the organisation of the World Bank. It explains the lending operation of the
World Bank. If further focuses on the role of World Bank in India.
LEARNING OBJECTIVES
Ø explain the objectives of the world bank

Ø describe the organisation of the world bank
Ø summarise the lending operation the world bank
Ø discuss the role of world bank in India
14.1 WORLD BANK AND INDIA
14.1.1 OBJECTIVES AND FUNCTIONS OF IBRD

1. Rendering assistance in the reconstruction and development of member
countries by facilitating investment of capital for productive purposes
and also helping for the restoration of economies from enormous
destruction brought about by the Second World War and also providing
encouragement to the development of productive resources of less
developed countries. Hence, the terms ‘Reconstruction’ and
‘Development’ have been used in naming the institution.
2. Helping in the establishment of the projects in backward areas, which
will have the greatest linkages with the hinterland, so that output,
employment and income may increase.
3. Developing the economic infrastructure base through the development
of power, transport, communications and irrigation sectors.
4. Assisting in the development of social infrastructure also, by financing
special programmes of development of education, health and training.
5. Helping special area development programmes as in drought prone
areas, flood prone areas, or ravine areas.
6. Promoting foreign private investment by guarantees of or through
participation in loans and other investments by the private investors.
7. Giving loans for productive purposes, out of its own resources, or out
of the funds borrowed by it, if private capital is not interested.
8. Promoting the long-range growth of international trade and the
maintenance of equilibrium in balance of payments by encouraging
international investment for the development of the productive
resources of the members.
9. Supporting special programmes which can relate to the development
of anything, e.g., forest development, ports development, agricultural
development, urban services, housing projects, sewerage development
or underground railways.
14.1.2 ORGANISATION OF THE WORLD BANK
Any country subscribing to the charter of BIRD is eligible to become its member.
A member has the right to withdraw its membership at any time provided it
undertakes to pay back all loans with interest on due dates. n case the Bank
incurs some financial loss in the year in which a country withdraws its
membership, it is required to pay on demand its share of loss. The World
Bank has a membership of 182.
IBRD consists of Board of Governors, Executive Directors and a President.

All the powers of the Bank are vested in and exercised by the Board of
Directors. Each member country is represented by one Governor and one
alternate Governor for a period of five years. The Board of Governors is required
to meet once a year. In order to carry out the day-to-day functions of the Bank,
the Governors have delegated their powers to a Board of Executive Directors.
Presently there are 22 Executive Directors. The President of World Bank is
also the Chairman of the Board of Executive directors. The meeting of the
Board of Executive Directors takes place regularly once a month. They
determine the policy of the Bank within the framework of the Articles of
Agreement. The loan and credit proposals made by the President are decided
by them. They are also required to present to the Board of Governors the
audited accounts, and administrative budget and an Annual Report on the
operations and policies of the Bank at its annual meeting. For executing the
working of the Bank, the President of the World Bank has a staff around 6,500
persons in Washington, in addition to about 1,200 consultants, many of them
ex-employees, and a 1,000 people in other countries. The President of the
IBRD is assisted by a number of Vice-Presidents and Directors of various
departments and regions.
14.1.3 LENDING OPERATIONS OF THE WORLD BANK

The Bank adopts two types of lending. The first once is for developing countries
that are able to pay near-market interest rates. The money for these loans
comes from investors around the world. These investors buy bonds issued
by the World Bank. The second type of loan goes to the poorest countries,
which are usually not credit-worthy in the international financial markets and
are unable to pay near-market interest rates on the money they borrow. Lending
to the poorest countries is done by a World Bank affiliate, the International
Development Association (IDA).
Following are the way by which the World Bank gives loans to its member
countries. (i) By granting loans out of its own funds; (ii) By participating in
loans of funds raised in the market of a member country or otherwise borrowed

by the World Bank; and (iii) By providing guarantee in part or in full for loans
made by private investors through the usual investment channel.
It is stipulated that the amount of outstanding of loans or guarantees provided

by the World Bank should not exceed 100 per cent of the Bank’s unimpaired
subscribed capital, reserves and surplus.
The World Bank gives loans or its guarantees on the following conditions:
(a) The WB is satisfied that in the prevailing market conditions, the

borrower is unable to obtain loans under conditions which the Bank
considers reasonable.
(b) The loans are for reconstruction or development, except in special
circumstances.
(c) If the Central Bank of the member-country gives full guarantee for
payment of the principal, interest on loan and other related charges.
(d) The project for which the loan from the WB is being sought is
recommended by a competent committee, after a careful study in its
written report; and
(e) The borrower is in a position to meet the Bank’s obligations.
The WB gives medium-term and long-term loans usually running up to the
completion of the project, for which the Bank has given the loan. Long term
loans are repayable over a period of 20 years or less, with a grace period of
five years. It is observed that the interest rate charges by the WB is calculated
in accordance with guidelines related to the bank’s cost of borrowing. There is
in addition, an annual commitment charge of 0.75 per cent year on the
outstanding balances.
Since the inception of lending operations of the WB in 1946, its lending

concentrated heavily upon the provision of capital for infrastructure projects,
such as, roads and railways, generation and distribution of electricity, irrigation
projects, telecommunications, port developments, etc., for the first two
decades. But since 1970, the emphasis in lending has shifted to the financing
of educational system in developing countries, creation of institutions for
financing industrial investment and provision to technical assistance for the
selection and appraisal of industrial projects and to assist in preparation of
agricultural projects. The present lending strategy of the WB places greater

emphasis upon investments affecting directly the welfare of the poorer sections
in the developing nations through assistance to projects raising the productivity
and standard of living. In this regard, mention may be made of the financing of
the projects for agricultural and rural development, education, nutrition
programmes, family planning, and provision of drinking water, low cost housing
and improvement of drainage and sewerage system in the developing countries.
In fact, the participation of WB in the overall structural and social development
of the LDCs has increased considerably during the last few decades.
During 1980’s the World Bank introduced two lending facilities for the member
countries. These were:
(a) Structural Adjustment Facility (SAF)
This facility was introduced by the IBRD in 1985 to assist the borrowing
countries in reducing their international payments deficits, while maintaining
the pace of growth. The funds provided under SAF are meant to finance imports
of goods, except those of luxury goods and military imports. These loans are
subject to stiffer conditions.
(b) Enhanced Structural Adjustment Facility (ESAF)
This facility was instituted in December 1987 for increasing the availability of
concessional funds to the poor member countries. Under those, the Bank
would provide new concessional resources aggregating SDR’s 6 million
financed through special loans and contributions obtained from the
development and OPEC countries. Like SAF, even this facility is aimed to
assist the borrowing member countries to reduce their BOP deficits and
stimulate growth. The repayment under this facility is to be made in 10 six-
monthly installments, commencing after 5.5 years of disbursement of loans.
It carries the interest rate of 0.5 per cent annum.
The World Bank’s Special Action Programme
The WB started its Special Action Programme (SAP) in 1983 to assist the
member countries to adjust to current economic environment. The SAP has
the following four elements:
(a) Expansion in lending for high priority operations that support structural
adjustments, policy changes, production for exports, fuller use of
existing capacity and maintenance of vital infrastructure;
(b) Accelerated disbursement of loans under the existing and new
investment commitments to ensure timely implementation of high-
priority projects;
(c) Expanding of advisory services on formulation and implementation of
appropriate policies, such as reviews of State enterprises, studies to
strengthen development - oriented capabilities, studies to increase
mobilisation of domestic resources, study of incentives for export
promotion and diversification, and exploration of ways to strengthen
debt-management capabilities; and
(d) Enlisting efforts by other donors for rapid disbursement of assistance in
support programmes of WB and the IMF. About SAP lending, it has been
decided that there cannot be more than 10 per cent of the IBRD lending.
Other Activities of the World Bank
In addition to the world-wide massive lending operations, the World Bank

performs several other activities including technical assistance, inter-
organizational co-operation, training, economic research and studies,
evaluation of operations and settlement of investment related disputes among
the member countries.
(a) Technical Assistance
The core element of the activities of the WB has been its programme of technical
assistance to the member countries. The technical assistance is concerned
with feasibility studies, engineering designs, construction supervision, execution,
engineering services, energy, transportation, industry etc. In 1975, the Bank
created Project Preparation Facility (PPF). Through this facility, the Bank makes
advances to the prospective buyers for enabling them to fill up gaps in project
preparation and creation of necessary institutional structure for it. The WB also
serves as an executing agency, in case of the projects financed by the United
Nations Development Programme (UNDP). Moreover, the Bank offers to the
member countries with advice on development planning, deputation of staff
members to render technical advice to the member countries, transfer of
technology service on evaluation and monitoring panels, etc.
(b) Inter-organizational cooperation
Another important activity of the WB is the promotion of cooperation among

several international organizations such as Food and Agricultural Organisation
(FAC), World Health Organisation (WHO), the United Nations Educational,
Social and Cultural Organisation (UNESCO), UNCTAD, GATT, UNDP, United
Nations environment Programme (UNEP), the United National Industrial
Development Organisation (UNIDO), the International Fund for Agricultural
Development (IFAD), the Asian Development Bank (ADB), International Labour
Organisation (ILO), etc. The WB has played active role in promoting
cooperation among these institutions on the basis of formal inter-organizational
agreements.
(c) Training
A staff college was established by the World Bank in 1958 for providing training
to the senior officials of the member developing countries. It is known as the
Economic Development Institute (EDI). There is a network of regional Institutes
of EDI. Seminars are organized by EDI in Washington, in collaboration with
regional training institutes.
(d) Economic Research and Studies
The WB started research in economic, social and several other fields in 1971.
About 3 per cent of its administrative budget is devoted to economic and social
research by 1980s, 165 research projects had been completed and 180 were
in progress. The Research Policy Council (RPC) was instituted by the World
Bank in 1983 with the object of providing leadership in the guidance,
coordination and evaluation of all research work undertaken by the Bank. The
research activities are undertaken by Bank’s own research personnel and
also in collaboration with outside researchers. The WB helps the LDCs also
to strengthen their indigenous research potential.
(e) Evaluation of Operations:
In order to assist the borrowers in the post-evaluation of their Bank-assisted

projects, the WB has created its operation Evaluation Department (OED).
The staff of OED undertakes audit of the various projects in collaboration with
officials of the member countries. The EDI also provides training to the staff of
the borrowing countries, in monitoring and evaluation of projects.
(f) Settlement of Investment related Disputes
The WB has created machinery for the settlement of disputes related to investment
between the member nations and foreign investors. This machinery was started
in 1966 and it is called Convention on the Settlement of Disputes between States
and Nationals, i.e., International Centre for Settlement of Investment Disputes
(ICSID). This provides facilities for the settlement by voluntary resources to
conciliation or arbitration of investment disputes between India and Pakistan and
the Suez Canal dispute between Egypt and the United Kingdom.
(g) Urban Development; Population Planning & Tourism
The WB activities have further diversified by taking urban development,

population planning with its activities. A Population Project Development and a
Population Studies Division have been set up in the Economic Department of
the Bank. The Bank’s first population mission visited Jamaica in 1976-77 to
assist that country’s government in preparing a long-range family planning
programme. Further, to assist the developing countries in increasing their
foreign exchange income through the development of tourism, the Bank has
established a new Tourism Projects Department which provides technical
assistance to the International Finance Corporation in making tourist
investment. The Bank’s tourism mission has visited many countries.
Thus, the World Bank is engaged in several activities for the benefit of
developing countries and also promoting global peace through global
development and welfare of all the people. According to World Bank Report
1995, the overall lending commitments of the Bank in that year were of the
order of 22.5 billion dollars.
14.1.4 ROLE OF WORLD BANK IN INDIA

India is one of the founder - members of the World Bank. In that capacity, India
held a permanent seat on its Board of Executive Directors for a number of
years. That position was threatened when China applied for a membership of
the World Bank.
The World Bank has been rendering substantial assistance to India in her
efforts at planned economic development. This is done by granting loans,
offering expert advice in various spheres, and training Indian personnel at the
Economic Development Institute.
In November 1951, a World Bank Mission came to India to review the progress
made by the country in economic development and to assess further
assistance that could be recommended to the Bank for consideration.
In the year 1952, the President of the World Bank visited India to explore the
possibilities of extending loan assistance for specific projects. This was
followed by visits by the Bank mission. In the year 1956, another Bank mission
visited India to review the progress made under the First Five year Plan and to
study the Second Plan. The Bank appointed a Resident Representative in
New Delhi, to be in close touch with the Government of India, for the purpose
of assessing the progress of development plans and projects.
In February 1960, a three-member Bank mission consisting of Sir Olive Franks,

Mr.Allen Prousal and Dr.Herman, visited the country to prepare report for
assistance to be given for the implementation of the Third Plan.
In June 1970, a Bank Mission visited Madhya Pradesh to examine State

Government’s request for a Rs.50 crores project to level up and reclaim 2.25 lakh
acres of the relatively shallow ravine land along the Chambal river and its tributaries.
In August 1970, a seven member Bank mission came to India to make a study
in depth of the family planning programme in Uttar Pradesh to assess the
feasibility of launching a special project for intensive family planning work.
Since August 1949 to June 1992, the World Bank had lent India 20,599.2 million
dollars in 147 loans. Of this loan assistance, more than 50 per cent was given
for the improvement of transportation, i.e., railways, ports, roads and aircraft.
Electric power development claimed about 28 per cent, while agriculture got
about 8 per cent of the total assistance given by the Bank to India.
India received 5,472 million dollar financial help during the Third Plan period
from the 12 - nation Aid India Consortium formed through the sincere efforts of
the Bank.
The signing of the Indus Water Treaty in September 1960 which ended the 13-
year old dispute between India and Pakistan was a great triumph for the Bank’s
honest intentions to help member countries.
The Bank gave a loan of 39 million dollars in 1971 and 1972 to the Punjab
Agricultural projects to purchase 8,000 tractors and other farm machinery to
boost farm products.
As of October 2001, India is the World Bank’s largest single borrower with
cumulative lending of more than 56 billion US dollars in combined market -
based loans from the WB and development credits from the IDA.
14.1.5 FUNCTION OF INTERNATIONAL FINANCE CORPORATION AND

ASIAN DEVELOPMENT BANK
The International Finance Corporation IFC is an affiliate of the World Bank. It
was established on 20th July 1956 with the object of assisting private enterprises
in developing countries by providing them with risk capital. The World Bank
grants loans only to member Governments or to private enterprises with the
guarantee of the member government concerned. Again, the World Bank
provides only loan capital to enterprises. It does not provide risk capital to the
private enterprises in member countries. In fact, the development of private
enterprises is held up for lack of adequate risk capital. Hence, there was an
urgent need for some international financial institution which would be willing
to provide risk capital to the private industrial undertakings in developing
countries. The IFC was set up to meet the particular requirement of private
industrial undertakings.
OBJECTIVES
IFC’s objective is to assist economic development by encouraging the growth
of productive private enterprises in its member nations, particularly in the
underdeveloped areas. Thus, it laid down the following objectives:
1. To undertake investment in productive private enterprises, in

association with private investors and without government guarantee
in respect of repayment of loans in cases where sufficient private capital
is not forthcoming on reasonable terms.
2. To act as a clearing house for brining together investment opportunities,
private capital of both domestic and foreign origin and the experienced
management.
3. The stimulate productive investment of private capital of both the
domestic and foreign origin.
4. To assist in the development of capital markets in the less developed
countries.
Functions of IFC
i. Direct investment
IFC invests in partnership with private investors from the capital exporting country
and/or from the country in which the enterprise is located. But its investments
will not be more than half of the capital requirements of the enterprise. The
minimum investment by the corporation in an enterprise is $1 million but there
is no upper limit. The corporation assistance is not tied to expenditure in any
particular country, but must be spent in the member countries. It is used to buy
machines and other equipment and to meet foreign exchange, local costs,
working capital and any other legitimate business expenses.
II. Foreign and Local Capital
The IFC participates in promoting productive private investment in developing

countries by way of equity and /or loan investment. It underwrites equity capital
and helps in sponsoring and bringing together investors for new enterprises.
Thus it secures the cooperation of both foreign and local enterprises. It helps
them in making feasibility studies of the proposed projects.
III. Technical Assistance
The IFC provides project sponsors with the necessary technical assistance
so that their enterprises are potentially productive and financially sound. For
this purpose, it undertakes financial studies and analysis. It also provides
policy assistance to member governments so that they may development the
necessary investment climate to attract foreign and local private enterprises.
IV. Capital Markets Development
The corporation has a capital markets department which provides specialised

resources for studying the problems and needs of the financial markets of
developing countries. It provides financial support and advice for the development
of financial institutions and helps in developing a legal, financial, and institutional
framework which may encourage local and foreign capital in developing countries.
The corporation has been instrumental in the promotion of financial institutions,
development finance companies, venture capital companies, mutual funds, etc.
by giving technical assistance to developing countries.
V. Help to small scale industries
The IFC also renders help to small scale industries in the form of advice for
the preparation of project reports and technical assistance. It has established
four such facilities for developing countries of different regions. They are the
South Pacific Project Facility, the Africa project development facility.
ASIAN DEVELOPMENT BANK
Asian Development Bank (ADB) was set up in Dec.1966 to faster the economic
development of Asian countries.
The objects of the bank are:
i. To promote investment in the ESCAP region of public and private capital

for development.
ii. To utilize the available resources for financing development giving
priority to those regional and sub-regional as well as national projects
and programmes which contribute more effectively to the harmonious
economic growth of the region as a whole.
iii. To help regional member countries in the coordination of their plans
and policies for development with a view to enabling them to achieve a
better utilisation of their resources.
iv. To provide technical assistance for the preparation and execution of
development projects and programmes, including the formulation of
specific project proposals.
v. To cooperate with the UN, its organs and subsidiaries, including in
particular the ESCAP and the national entitles concerned, the
investment of development funds in the region.
vi. To render such other services and to undertake such other activities
as may further its objectives.
Functions of ADB
i. Financial Assistance
The bank provides financial assistance in the form of grants and loans. The
ADB grants loans on the basis of certain criteria. At the time of evaluating
projects that is propose to finance, the bank considers their economic, technical
and financial feasibility, their effects on the general activity of the concerned
country, their contributions to the removal of economic bottlenecks and their

capacity to repay the loans. In granting loans to the various types of projects
the ADB charter does not impose any restrictions. Even the minimum and
maximum limits of loan are left open to be decided by the bank on merits and
viability of the projects.
ii. Technical Assistance
The ADB also provides technical assistance to member countries out of the
Technical Assistance Special Fund. The technical assistance is provided to
the members in ECAFE region through their Government, agencies, regional
institutions and private firms. It may be in the form of grants or loans or both.
The bank’s technical assistance has two main objectives.
(a) To prepare and finance and implement specific national and/or regional
development plans and projects.
(b) To help in the working of existing institutions and/or the creation of new
institutions on a national or regional basis in such areas as agriculture,
industry, public administration etc.
iii. Surveys and Research
One of the functions of ADB is to conduct surveys and research in order to

formulate policies for the future and to promote regional economic integration.
It brings out an annual report in which it highlights the achievements, prospects
and failures relating to the economic development of the member countries of
the ECAFE region and also suggests measures to solve their problems.
iv. Poverty Reduction
The bank’s greater emphasis in the 1990s would be on poverty reduction, social
infrastructure and conservation of natural environment. In promoting economic
growth, the bank stresses the importance of increasing productivity. Productivity
improvement depends on new investments, the efficiency with which new and
existing capitals are used and incorporation of technological changes.
CHECK YOUR PROGRESS
A. State whether the followings statement are True or False.
1. The World Bank was established on Dec.25, 1944.

2. The World Bank provides long term finance
3. The important activity of the world bank is the promotion of cooperation

among several international organizations
4. The international bank for reconstruction and development popularly
known as the World Bank.
SUMMARY
World Bank is a sister institution of the IMF. Both the institutions came into
existence simultaneously as a result of the Bretton Woods Conference held
in 1944. The objective of the World Bank is to eliminate the long-term
disequilibrium in the balance of payments of member countries by advancing
long-term loans to them for development purposes. The aim of the bank is the
reconstruction and the development of the economics of the member countries.
GLOSSARY
IBRD : International Bank for Reconstruction and Development was established

in 1945 to help countries to undertake development and reconstruction work
after the Second World War. It is also known as World Bank.
SAF : The Bank has introduced a facility known as structural adjustment facility
to borrowing countries so as to enable them to reduce their balance of
payments deficits while maintaining their economic growth.

MODEL QUESTIONS
1. Describe the organisation structure of IBRD.

2. What have been the objectives of IBRD?
3. Briefly describe the lending operations of the IBRD.
BOOKS FOR REFERENCE
1. M.L.Jhingan - International Economics

2. Francis Cherunilam - International Economics
5. Kindleberger - International Economics
192 GATT & WTO
UNIT 15
GATT & WTO
STRUCTURE
Overview
Learning Objectives
15.1 GATT
15.1.1 Objectives of GATT
15.1.2 Provisions of GATT
15.1.3 The Sixth Round of GATT
15.1.4 The Seventh Round of GATT
15.1.5 Defects of GATT
15.2 World Trade Organisation (WTO)
15.2.1 Objectives of WTO
15.2.2 Functions of WTO
15.2.3 Structure of WTO
15.2.4 Multi-Lateral Trade Agreements
15.2.5 Patent Law
Summary
Glossary
Model Questions
Books for reference
OVERVIEW
In this unit, you are going to learn the objectives of GATT and provisions of GATT.
The sixth round of GATT and seventh round of GATT are also discussed. It explains
the defect of GATT. It focuses on the objectives of and functions of WTO. It further
focuses on multilateral trade agreements. Patient law is also explained.
LEARNING OBJECTIVES
Ø explain the objectives of GATT

Ø describe the functions of WTO

Ø discuss the provisions of GATT
Ø explain the Tokyo round
Ø summarise the Kennedy Round
Ø bring out the functions of WTO
Ø explain the objectives of WTO
Ø discuss the multilateral trade agreements
15.1 GATT
In 1947, 23 nations met at Geneva and drew up a plan for the reduction of
import duties and also against future increase in duties by the negotiating
countries. This came to be known as the General Agreement of Trade and
Tariffs. It came into effect on a provisional basis on July 9, 1948. The GATT
was not a statute to be compulsorily enforced on member countries, but an
instrument forged by common consent and adhered to voluntarily by them. It
was an intergovernmental instrument, providing for rights and obligations in
the field of commercial policy of the member countries with the principal object
of promoting international trade through reciprocal and mutually advantageous
arrangements by reducing trade barriers, customs, tariffs and discriminatory
practices. In short, the GATT stood for promotion of free, non-discriminatory,
multilateral trade and for abolishing all unfair trade practices.
15.1.1 OBJECTIVES OF GATT

The objectives of GATT agreement were based on some fundamental
principles contained in Code of International conduct the salient principles
and objectives of GATT can be enumerated as below:
i. The international trade should be carried on the basis of non-

discrimination, reciprocity and transparency.
ii. The protection to the domestic industries should be given only by
means of tariffs and by no other means.
iii. The Most Favoured Nation (MFN) principle should be followed by all
the members. The members should enter into consultations for the
avoidance of damage to the interests of the members.
iv. The multilateral negotiations should be carried to reduce tariff and non-
tariff barriers to trade.
194 GATT & WTO
The framework of these principles had been amplified as follows :
a) To encourage full employment and large and steadily growing volume

of real income and effective demand;
b) To ensure the full use of world resources.
c) To bring about the expansion of world production and exchange.
d) To settle the disputes through consultation within the framework of
GATT.
15.1.2 PROVISIONS OF GATT
In order to realise the above stated principles and objectives, GATT had made
the following provisions:
1. Most favoured national (MFN) Clause
The significant prevision of GATT was the ‘Most Favoured Nation’ clause, which
connotes that all contracting parties of the Agreement would be considered
as most favoured nations and the benefits extended to one, should also be
extended to all contracting parties. In short, there should be no discrimination
among the nations, and trading should be carried on the principle of non-
discrimination and reciprocity. In essence, this clause discouraged the member
countries from granting any new trade concessions, unless those were
multilaterally agreed.
However, there were several ‘Escape Clauses’. The less developed countries
were assured of the right to discriminate under certain specific circumstances.
For instance, dumping and export subsidy might be countered by trade
measures, only against the offending country. Further, special concessions
were allowed for trade with former colonies of developed Western countries.
2. Quantitative Restrictions on Imports
The GATT rules, as a matter of principle, prohibited the use of import quota
fixation and import licences, under Article XI of the GATT agreement. However,
there were exceptions to this rule, under specific circumstances:
(a) Countries which were facing balance of payments difficulties could

use the device of import quota fixation. But this quota should be limited
only to the extent necessary to stop a serious decline in foreign
exchange reserves. The IMF should be consulted in this matter.
(b) Under-developed countries might resort to quota fixation, only under

procedure approved by the GATT.
(c) Quotas might be applied to agricultural and fishery products, if domestic
production was subject to equally restrictive controls
(d) When a foreign country was exporting products at artificially low
(dumped) prices or at the subsidized prices, the affected country was
allowed by the GATT to take suitable protective action.
(e) The countries were allowed to form Customs Union or free trade areas
under Article XXIV of the GATT agreement, provided their aim was to
promote trade among the constituent countries, and not to raise trade
barriers against other contracting parties.
3. Tariff Negotiations and Tariff Reduction
GATT considered that tariffs were the important obstacle to international trade
and therefore, encouraged negotiations for the reduction of high tariffs. The
negotiations for the reduction of tariff, should be conducted on a reciprocal
and mutually advantageous basis, taking into consideration the varying needs
of individual contracting parties. Article II of the GATT specified that all
concessions granted by contracting parties, as a consequence of negotiations,
must be entered in a Schedule of Concessions; A concession might assume
the form of a reduction in the rate of import tariff or an agreement to bind, i.e.,
not to hike the existing rate of duty. Once a concession was included in the
schedule of concessions, it could not be withdrawn except under specified
circumstances. It meant that provisions of schedule of concessions, binding
clause and tariff negotiations created a strong in-built bias towards the lowering
down of rates of import tariff in the GATT. The negotiation procedure concerning
tariff reduction was bilateral- multilateral. It was bilateral as two contracting
parties entered into negotiation of tariff reduction on a selective commodity-
to-commodity basis. The tariff reduction agreed between any two negotiating
parties was to made applicable to all the contracting parties under the ‘Most
Favoured Nation’ clause. This was the multilateral aspect of tariff negotiations.
4. Subsidies and Countervailing Duties
It was recognised by the GATT that the subsidies were alternative to tariff. The
Tokyo Round of the GATT in 1970s considered it necessary to specify the
code of conduct related to subsidies. The industrial countries agreed to a
196 GATT & WTO
complete ban on export subsidies in the case of manufactured products. The

LDC’s were however, exempted from this stipulation. The member countries
were required to avoid subsidies on the export of primary products in principle.
In case the subsidies resulted in harm to the interest of importing countries,
the agreement authorised them to take resort to countervailing duties. In case
any country was found to take recourse to dumping, i.e., the export price of a
product was lower than its domestic price, the affected country was allowed
to impose the countervailing or anti-dumping duties to the extent that the
dumping got neutralised. However, the country resorting to countervailing or
anti-dumping duties should not impose duties at a higher rate than was required
to offset the margin of dumping and the affected industry in the importing
country should not acquire thereby a net additional protection.
5. Complaints and Waivers
Article XXII of the GATT made provision for dealing with any complaint from a
contracting party related to the operation of the Agreement. The complainant
could request the other party for consultation, if the former felt that the action
of the latter had proved injurious and the former could not reap the benefits
under the GATT Agreement. Article XXV of the GATT laid down the procedure
for granting waiver to some contracting party, from the application of the
provisions of the GATT. Ordinarily, the waivers were not granted unless those
were approved by two-thirds of the voting contracting parties.
6. Settlement of Disputes
The GATT had provisions for the settlement of disputes among the contracting
parties. Initially, the contracting parties would hold talks on bilateral basis to
resolve the disputed matter. In case of failure, the matter could be referred to
a panel of experts drawn from countries having no direct interest in the matter.
This panel or committee, after a careful study, used to make a recommendation
or ruling to be observed by the offending party. In case the offending party did
not comply with the ruling or did not act upon the recommendations of the
panel, the aggrieved party was authorised to retaliate by withdrawing some or
all concessions offered to the offending country. This, disputes settlement
procedures of the GATT rested upon direct consultations, conciliation and
third party adjudication. GATT had generally proved successful, in resolving
disputes among the contracting parties.
15.1.3 THE SIXTH ROUND OF GATT

Kennedy Round
The sixth conference of GATT (1963-67) popularly known as Kennedy Round

was held at Geneva in which 54 countries participated for trade negotiations.
This conference was held at the initiative of President Kennedy of USA, and
hence the name Kennedy Round. President Kennedy took the initiative in
securing concessions from EEC. EEC and the USA were complaining against
each others protective measures. The results of Kennedy Round included
the tariff reduction by the advanced countries like the USA, the EEC countries.
Japan and Canada on an average to the extent of 35 per cent. The incidence
of tariff reduction was not uniform in case of different groups of commodities.
The maximum tariff cut had been extended in case of chemicals, paper, etc.
In the case of products like iron and steel, fuels, textiles, the tariff cut was very
low. In addition, the deliberations were held on non-tariff barriers, agriculture
and tariff reduction on the exportable products of the LDCs. No doubt, the
Kennedy Round of the GATT could make a significant contribution in effecting
substantial tariff cuts; yet the achievements were still short of the objective.
15.1.4 THE SEVENTH ROUND OF GATT

Tokyo Round
The Seventh GATT conference was held at Tokyo (1973-79) and hence the
name Tokyo Round. This conference deliberated upon the issues including
tariff reductions, removal of non-tariff barriers, coordinated scaling down of all
trade barriers in selected sectors, trade liberalization in agriculture, etc.
Tariff reduction
The tariff reduction agreed by the leading countries such as the USA, the EEC
and Japan, on an average, was of the magnitude of 31 per cent, 27 per cent
and 28 per cent respectively. The negotiated tariff reduction by the contracting
parties was to be phased over 8 years commencing from 1980.
Non-tariff barriers
The Tokyo Round laid down a code of conduct for nations to follow in respect
of non-tariff barriers. This code included (a) agreement on a code about the
government procurements, (b) uniformity in the application of duties in
198 GATT & WTO
countervailing and antidumping cases, and (c) a generalized system of

preferences to the manufactured, semi-manufactured and selected other
exports of the LDS’s countries. However, many products such as textiles,
shoes, consumer electronics, steel and several other products that were of
very vital interest for the LDS’s remained excluded.
Removal of technical barriers
An agreement was reached through Tokyo Round about the removal of

unnecessary trade barriers existing in the form of technical standards. The
provision in the agreement was made concerning complaints related to the
violation of the code of technical standard by the contracting parties and
redressal thereof.
Import licensing procedures
The Tokyo Round resulted in an agreement concerning the simplification of

import licensing procedures. It provided for automatic grant of approval of the
application on the inflow of goods, simplification of licensing procedure in case
of quota and other import restrictions. It also provided for creating institutions
and procedures for consultation and settlement of disputes between the
contracting parties.
Customs valuation
An agreement was reached among the nations providing for a fair, natural and
uniform system for the valuation of goods for customs purposes.
15.1.5 DEFECTS OF GATT

1.No enforcing authority
The GATT had attempted to prescribe an international code of conduct in the

sphere of trade. But, there was no enforcement authority to oversee the
compliance of GATT regulations by contracting parties and to settle their trade
disputes effectively.
2.Membership - very diverse nature
Membership of the GATT was of diverse nature, with different political and
economic interests. Hence, making successful negotiations on trade matters
and arriving at a common understanding became very difficult. This created
lot of difficulties in the formulation of general rules.
3. Principles of reciprocity and non-discrimination
The GATT had been stressing upon the principles of reciprocity and non-
discrimination. The reciprocity meant that two contracting parties must provide
equivalent benefits or concessions to each other. It also implied that they could
adopt equivalent trade restrictions too. The principle of non-discrimination, at
the same time emphasized upon the uniform policy for all the contracting parties.
There was in-built bias and contradiction on account of these two principles.
4. Commodity-to-Commodity based negotiations
The GATT adopted the practice of commodity-to-commodity based

negotiations. These principles had gone against the interests of developing
countries which were mainly exporters of primary products. The developed
countries benefited much in this process, as they had better bargaining power
over LDCs. In addition, this approach was responsible of the prolonged
deliberations at the various rounds of GATT negotiations.
5. Little benefits for the LDCs
Though the forum of GATT had larger number of LDCs, they could not bargain
effectively and they could not realise any tangible benefits. In short, they could
not secure easy and liberal access to the markets of developed countries.
6. Free Trade Area or Customs Union
Article XXIV of the GATT permitted the member countries to organize

themselves into free trade areas or customs unions. The strong regional trading
blocks such as European Union, North American Free Trade Association,
Association of South East Asian Nations etc., had emerged and caused serious
distortions in the world trade. They undermined the basic principles of GATT.
7. Non-representative Body
The GATT was considered as a non-representative body, as for a long time,

the East European countries of erstwhile Soviet Block and China remained
outside the GATT.
15.2 WORLD TRADE ORGANISATION (WTO)
15.2.1 OBJECTIVES OF WTO

The preamble to the WTO mentions the following as its objectives:
200 GATT & WTO
1. To conduct its relations in the field of trade and economic endeavor in

such a manner to raise standards of living.
2. To allow for the optimal use of the world’s resources in accordance
with the objectives of sustainable development, seeking both (a) to
protect and preserve the environment, and (b) to enhance the means
for doing so in a manner consistent with respective needs and
concerns at different levels of economic development.
3. To make positive efforts designed to ensure that developing countries,
especially the least developed among them, secure a share in the
growth in international trade commensurate with the needs of their
economic development.
4. To achieve these objectives by entering into reciprocal and mutually
advantageous arrangements directed towards substantial reduction
of tariffs and other barriers to trade and the elimination of discriminatory
treatment in international trade relations.
5. To develop an integrated, more viable and durable multilateral trading
system encompassing the GATT, the results of past liberalization efforts,
and all the results of the Uruguay Round of multilateral trade
negotiations.
6. To ensure linkages between trade policies, environmental policies and
sustainable development.
15.2.2 FUNCTIONS OF WTO
The functions of the WTO are as follows:
1. Facilitating of the implementation, administration and operation of the

objectives of the Agreement and of the Multilateral Trade Agreements.
2. Providing the framework for the implementation, administration and
operation of the Plurilateral Trade Agreements regarding trade in civil
aircraft, Government procurement, trade in dairy products and bovine meat.
3. Providing the forum for negotiations among its members regarding
their multilateral trade relations in matters connected with the
agreements and framework for the implementation of the results of
such negotiations, as decided by the Ministerial Conference.
4. Administering the Understanding on Rules and Procedures governing

the Settlement of Disputes of the Agreement.
5. Co-operating with the IMF and the World Bank and its affiliated agencies
in order to achieve greater coherence in global economic policy making.
15.2.3 STRUCTURE OF WTO
The Ministerial Conference composed of representatives of all the members,
who meet at least once in every two years, head the structure of the WTO. It
carries out the functions of the WTO by taking necessary actions to this effect.
It has the General Council, which consists of representatives of all the members
to oversee the operation of the WTO Agreement and ministerial decisions on
a regular basis. It also acts as a Dispute Settlement Body (DSB) and a Trade
Policy Review Body (TPRB), each of which having its own Chairman.
Under the General Council, the various Councils such as the Council for Trade
in Goods, the Council for Trade in Services and the Council for Trade Related
Aspects of Intellectual Property Rights (TRIPs) are operating. These Councils
have their subsidiary bodies. The councils and subsidiary bodies meet so as
to carry out their respective functions.
Besides the above, the Committee on Trade and Development, the Committee
on Balance of Payments Restrictions and the Committee on Budget, Finance
and Administration are also functioning to carry out the functions assigned to
them by the WTO Agreement, the Multilateral Trade Agreements and any
additional function assigned to them by the General Council.
The Director General heads the Secretariat of the WTO. The Ministerial
Conference appoints the Director General and also sets out his powers, duties,
and conditions of service and terms of office. He is appointed for a period of
four years. He has four deputies from various member states.
The Director General appoints the staff members of the Secretariat. He also
determines their duties and conditions of service as per the regulations adopted
by the Ministerial Conference.
The Director General presents the annual budget estimates and financial
statement of the WTO, to the Committee on Budget, Finance and
Administration. On receipt of those estimates and financial statements, the
Committee, reviews them and makes recommendations to the General Council
202 GATT & WTO
for final approval. The General Council adopts the annual budget estimates
and financial statements by a two-third majority. The rules and practices, of
the GATT regulate the financial aspects as to the scale of contributions and
the budget.
The WTO follows the practice of decision – making by consensus, as followed

under the GATT 1947. In case, a decision cannot be arrived at by consensus, the
matter at issue is decided by 2/3rd majority voting based on “One Country, One
Vote”. But in the case of interpretation of the provisions of the agreements and
waiver of a member’s obligations, 3/4th majority decides it. However, amendments
relating to general principles like MFN all members must approve treatment.
Fig.1 illustrates the structure of WTO
Ministerial Conference - Head of the Structure of the WTO

↓
General Council - Overseas the Operations of the
WTO Agreement & Ministerial
Decisions
↓
- Councils (3 Nos)
↓
- Subsidiary Bodies
↓
Committees (3 Nos)
↓
Director General - Head of the Secretariat
↓
- Four Deputees
- Staff Members of Secretariat
STRUCTURE OF WTO
15.2.4 MULTILATERAL TRADE AGREEMENTS

The Agreement establishing the WTO consists of the following agreements:
I. Multilateral Agreements on Trade in Goods
According to the general agreement on trade in goods, the GATT 1994 includes
GATT 1947 as amended up to January 1, 1995 when the WTO Agreement
came into force. It also includes the provisions of specified legal instruments,
the Marrakesh Protocol to GATT 1994 and the following understandings:
(i) Article II of GATT 1994
With a view to ensure transparency of the legal rights and obligations, the
nature and level of any “Other duties or Charges” levied on bound tariff items
in the Schedules of concessions continue with effect from April 15, 1995.
(ii) Article XVII of GATT
In order to ensure transparency of the activities of state trading enterprises,

members are required to notify such enterprises to the Council for Trade in
Goods for review by the working party at least once in a year and report to the
Council.
(iii) Understanding on Balance of Payment Provisions of GATT
Members imposing restrictions for purposes of balance of payment should do

so in the least disruptive manner. They should give preference to price-based
measures such as import surcharges, import deposits or measures, which
affect the price of imported goods. They should avoid the imposition of “New”
quantitative restrictions. They should publicly announce “as soon as possible”
time schedules for the removal of restrictive import measures for purposes of
balance of payments. The committee on Balance of Payments Restrictions
carries out consultations with a view to review all restrictive import measures
taken for balance of payments purposes.
(iv) Article XXIV of GATT 1994
The Agreement on Customs Unions and Free Areas clarifies and reinforces the
criteria and procedures for reviewing new or enlarged customs unions or free
trade areas and for evaluation their effects on third parties. The Agreement also
clarifies the procedure for any compensatory adjustment in the event of
contracting parties forming a customs union seeking to increase a bound tariff.
(v) Understanding on the Interpretation of Article XXVIII
Article XXVIII covers modification of GATT Schedules. It lays down new

procedures to negotiate compensation when tariff bindings are modified or
withdrawn.
204 GATT & WTO
Agreements included in the General Agreement on Trade in Goods
The general agreement on trade in goods includes various agreements dealing

with different aspects related to trade in goods as given below:
1. Agreement on Agriculture
The agreement on agriculture covers the aspects such as domestic subsidies,

exports subsidies, minimum market access commitment, domestic support,
sanitary and phytosanitary and food aid operations.
The agreement on agriculture seeds to open national markets to international

competition by replacing non-tariff measures with normal customs duties that
would be progressively reduced. It also seeks to check overproduction by
progressively reducing Government aids that encourage overproduction. Hence
surpluses are either disposed of through export subsidies or destroyed.
Besides, it seeks new disciplines on export competition and reduction in
subsidies along with the volume of subsidized exports.
(i) Domestic Subsidies
Domestic subsidies are divided into two namely,
(a) Non-product specific subsidies given for all crops : They include
subsidies given for fertilizers, water, electricity, seeds and credit and
credit, and
(b) Product-specific Subsidies given for specific crops : n our country,
they are in the form of minimum support price for some agricultural crops.
While calculating total subsidies given to farmers known as the total Aggregate
Measurement of Support (Total AMS), both types of subsidies mentioned above
must be totaled together. In order to be exempted from any obligation to reduce
its subsidies a developing country’s total AMS in any year, should not exceed
10 per cent of the value of total agricultural production in that year. The subsidy
is to be calculated at the international price for the commodity.
(ii) Export subsidies
WTO members are required to reduce the value of direct export subsidies to
a level of 36 per cent below the 1986-90 base period level and that of quantity
of subsidized exports by 21 per cent over the six-year implementation period.
In the case of developing countries, the reductions are 2/3rd to those of
developed countries over a ten-year period. But no such reductions apply to

the least developed countries.
(iii) Minimum Market Access Commitment
The minimum market access commitment applies to those countries that

maintain various types of restriction on agricultural imports. Therefore, they
are required to convert those restrictions into tariffs and reduce those tariffs
by 36 per cent over the six – year period. Such countries are also required to
allow a minimum market access opportunity of 3 per cent of their domestic
consumption for foreign agricultural consumption for six years, and the same
will rise to 5 per cent after that period. These commitments apply only when a
country is obliged to render its import controls in terms of tariffs. In the case of
developing countries, tariffs on agricultural products are to be reduced by 24
per cent over a period of ten years. In case of least developed countries, no
such tariff reduction is required.
(iv) Domestic Support
Domestic support measures have a minimum impact on trade. They are called
as green box policies. They are excluded from reduction commitments. Such
policies include general Government services in the areas of research, disease
control, and infrastructure and food security. In includes direct payments to
producers in the form of income support, structural adjustment assistance,
and direct payments under environmental programmes and under regional
assistance programmes.
Besides, there are other policies, which are not to be included in the Total AMS
reduction commitments. Examples of such policies are direct payments under
production limiting programmes, certain Government assistance measures
to encourage agricultural and rural development in developing countries and
other support measures. In the case of developed countries these should
make up only 10 per cent of the value of production of individual products or of
the total agricultural production. However, it is 5 per cent in the case of
developed countries.
(v) Sanitary and Phytosanitary Measures
Sanitary and phytosanitary measures are applicable to food safety and animal
and plant health measures. The agreement recognizes that Governments
206 GATT & WTO
have the right to take sanitary and phytosanitary measures so as to protect

human, animal or plant life or health. However, where identical or similar
conditions prevail they should not arbitrarily or unjustifiably discriminate between
members. The agreement seeks to ensure that animal and plant health and
safety measures do not serve as unwarranted trade barriers. The agreement
lays down procedures and criteria for assessing the risk and determining
appropriate levels of sanitary or phytosanitary protection.
(vi) Food stocking and Food Aid
The agreement recognizes that during the interim period least developed and
net food-importing developing countries may experience negative effects with
regard to supplies of food imports. So, it sets out objectives for providing food
aid and basic foodstuffs in full grant form and aid for agricultural development.
Further, it refers to the possibility of providing short-term financing to commercial
food imports by the IMF and the World Bank.
A Committee on Agriculture has been established in order to monitor and review

the implementation of the provision of the Agriculture Agreement.
2. Agreement on Textiles and Clothing
The Agreement on Textiles and Clothing aims at securing the integration of

the textiles and clothing sector into the GATT 1994. Integration means that
trade in tops and yarns, fabrics, made-up textile products, and clothing will be
governed by the General Rules of GATT. All (Multi-Fibre Agreement MFA)
restrictions existing on December 31, 1994 have been carried over into the
new Agreement and would be maintained until such time as the restrictions
are removed or the products integrated into the GATT. In the case of non-MFA
restrictions maintained by some members, they would also be brought within
the purview of the GATT 1994 within one year of the coming of the Agreement
into force or phased out progressively by 2005. The integration of this sector
would take place in four phases. Firstly on January 1, 1995 each party was
integrated into GATT products from the specific list in the Agreement, which
accounted for not less than 16 per cent of its total volume of imports in 1990.
In the second phase beginning January 1, 1998, products, which accounted
for not less than 17 per cent of 1990 imports, would be integrated. In the third
phase beginning January 1, 2002, products, which accounted for not less
than 18 per cent of 1990 imports, would be integrated. In the fourth phase all
remaining products would be integrated at the end of the transition period on
January 1, 2005.
There is also a specific transitional safeguard mechanism in case of products

not yet integrated into the GATT 1994 at any phase. Action can be taken against
an individual exporting country where it is found to the importing country that
overall imports of a product were entering the country in large quantities so as
to cause serious damage to the relevant domestic industry. Such an action
can be taken either by mutual agreement following consultations or unilaterally
but subject to the review of the Textile Monitoring Body. Safeguard restraints
can be in operation for three years without extension or until the product is
integrated into the GATT.
As part of the integration process, all members shall take necessary actions
in the area of textiles and clothing so as to follow GATT Rules and improve
market access and ensure the application of policies regarding fair and
equitable trading conditions and avoid discrimination against imports.
3. Agreement on Technical Barriers to Trade
This Agreement extends and clarifies the Agreement on Technical Barriers to

Trade reached in the Tokyo Round It aims at ensuring that technical negotiations
and standard and testing and certification procedures do not create unnecessary
obstacles to trade. But it recognizes that countries have the right to establish
protection on human, animal or plant life or health or the environment. A code of
Good Practice for the preparation, adoption and application of standards by
standardizing bodies has been included into the Agreement.
4.Agreement on Trade Related Aspects of Investment Measures (TRIMs)
Agreement on TRIMs calls for the removal of all trade related investment
measures within a period of five years. These measures relate to quantitative
restrictions and national treatment. Particularly, they are confined to measures
such as investment in identified areas, level of foreign investment for treating
foreign companies at par with national companies, export obligations and use
of local raw materials. The agreement prevents the imposition of any
performance clauses on foreign investors with regard to the earnings of foreign
exchange, foreign equity participation, and transfer to technology. It requires
208 GATT & WTO
that foreign investment companies be treated at par with national companies.

It prevents the imposition of restrictions on areas of investment. It requires
that raw materials, components and intermediates be freely imported.
It recognizes that certain investment measures restrict and distort trade. So it

requires mandatory notification of all non-confirming TRIMs and their removal
within two years for developed countries, within five years for developing
countries and within seven years for least developed countries. It established
a Committee on TRIMs to monitor the implementation of these commitments
and report to the Council of Trade in Goods annually.
iv. Agreement on Anti-dumping
Article VI of the GATT enables the contracting parties to apply anti-dumping

measures where dumped imports cause injury to a domestic industry in the
importing member country. The revised Agreement is an improvement over
the Tokyo Round Agreement. It provides the following: greater clarity, more
detailed rules and the criteria to be taken into account for determining injury
caused by dumped imports to domestic industry, the procedure to be followed
in initiating and conducting anti-dumping investigations, and the implementation
and duration of anti-dumping measures, and dispute settlement relating to
anti-dumping actions taken by domestic authorities. As per the new rules, an
anti-dumping investigation should be immediately terminated if the “Margin of
Dumping” is less than 2 per cent of the export price or the volume of dumped
imports from a particular country is less than 3 per cent of the total imports of
that product subject to a ceiling of 7 per cent of all such dumped imports.
5. Agreement on Subsidies and Countervailing Measures (SCM)
The Agreement on Subsidies and Countervailing Measures is applicable to

non-agricultural products. It classifies subsidies into prohibitive, non-actionable
and actionable categories. The prohibitive category includes subsidies with
high trade-distorting effects. They are export subsidies and those that favour
the use of domestic over imported goods. Developing countries having a per
capita income of less than $ 1,000 have been exempted from the prohibition
of export subsidies. The non-actionable subsidies include the subsidies that
are not specific to an enterprise or industry or a group of enterprise or industries.
Actionable subsidies are actionable by a trading partner if its interests are
adversely affected. It can seek remedy by having countervailing duties or follow

the dispute-settlement procedures.
Developing countries have been exempted from certain subsidy practices

namely, investment subsidies, agricultural input subsidies generally available
to low income / or resource – poor farmers, and measures to encourage
diversification from growing illicit narcotic crops.
The Multilateral Agreement on Trade in Goods also includes agreements on

Customs Valuation, Pre-shipment Inspection, Rules of Origin, Import Licensing
Procedures and Safeguards.
General Agreements on Trade in Services (GATS)
General Agreements on Trade in Services cover all internationally traded

services. Foreign services and service suppliers would be treated at par with
domestic services and service suppliers. But Governments may specify
specific Most Favoured Nation (MFN) exemptions. Such specifications will be
reviewed after 5 years, with a normal limitation of 10 years. It requires
transparency i.e. it includes the publication of all relevant laws and regulations
regarding services trade. International payments and transfers regarding trade
in services shall not be restricted, except in the event of balance of payments
difficulties where such restrictions will be temporary, limited and subjects to
conditions. Any liberalization of trade in services would be progressive in
character. It would be through negotiations at five-year intervals so as to reduce
or remove the adverse effects of measures on trade in services and to increase
the general level of specific commitments by Governments.
It sets out special conditions relating to individual sectors. Incase of movement

of natural persons, it permits the Governments to negotiate specific
commitments applicable to the temporary stay or people for the purpose of
providing a service. It does not apply to persons seeking permanent
employment or residence in a country.
In the field of financial services, it establishes the right of Governments to take

appropriate measures to protect the interests of investors, depositors and
policyholders, and to ensure the integrity and stability of the financial system.
They came into effect 6 months after the WTO came into force.
210 GATT & WTO
In case of telecommunications, the Agreement requires a Member to establish,

construct, acquire, lease, operate or supply telecommunications, transport
networks and services and make it available to the public. However, a developing
country may place reasonable conditions on the following:
1. Access to and use of public telecommunications, transport networks

and services for strengthening its domestic telecommunications
infrastructure and service capacity, and
2. To increase its participation in international trade in telecommunications
services in co-operation with the International Telecommunication Union
and the International Organisation for Standardisation.
Further, the GATS will also apply to aircraft repair and maintenance services,
marketing of air transport services and computer reservation services.
The Governments have agreed to set up working parties on the following:
1. Trade in services and environment to examine and report, with

recommendations, on the relationship between services trade and
environment, including the issue of sustainable development.
2. Professional services to examine and report, with recommendations,
on the disciplines necessary to ensure that measures relating to
qualifications requirements and procedure, technical standards and
licensing requirements in the field of professional services do not
constitute unnecessary barriers to trade.
The GATs also contain consultations and dispute settlement and the
establishment of a Council on Services.
Agreement on Trade – Related Aspects of Intellectual Property Rights

(TRIPs)
The TRIPs Agreement covers seven categories of intellectual property. They are:
1. Copyright and Related Rights
The parties are required to comply with the Berne Convention for protecting
their literary and artistic works. Literary works include computer programmes
also. Parties such as authors of computer programmes, performers on a
phonogram, producers of phonograms (sound recordings) and broadcasting
organizations are to be given the right to authorize or prohibit the commercial
rental of their works to the public. A similar exclusive right applies to films also.
The protection to performers and producers of sound recordings are to be
given for not less than 50 years and that of to broadcasting organizations for
at least 20 years.
2. Trademarks
A trademark constitutes any sign, or any combination of signs, capable of

distinguishing the goods or services, of one undertaking from those of other
undertaking. Such signs or combinations of such signs are eligible for registration
as trademarks. The owner of a registered trademark has the exclusive right to
prevent all third parties using in the course of trade identical or similar signs for
goods or services without the consent of the owners. Initial registration and
each renewal of registration of a trademark are made for a period of not less
than seven years. The registration of a trademark is renewable indefinitely.
3.Geographical Indications
Geographical indications indicate the identity of a good as originating in the

territory of a Member, or a region or locality in that territory where a given
quality or reputation of the good is essentially attributed to its geographical
origin. Members should provide the legal means for interested parties so as to
prevent the use of any indication, which misleads the consumer regarding the
origin of goods and any use, which would constitute an act of unfair competition.
4.Industrial Designs
Industrial designs are protected for a period of 10 years. Owners of protected

designs can prevent the manufacture, sale or importation of articles bearing or
embodying a design, if it is a copy of a protected design for commercial purposes.
5.Patents
Patents shall be available for any inventions, in all fields of technology, provided
they are new, involve an inventive step and are capable of industrial application.
Patent owners shall have the right to assign, or transfer by succession, the
patent and to conclude licensing contracts.
Inventions may be excluded from patentability when their commercial

exploitation is prohibited due to public order or morality. Besides, diagnostic,
therapeutic and surgical methods for the treatment of humans or animals,
212 GATT & WTO
plants and animals other than micro-organisms, and essentially biological

processes for the production of plants or animals other than non-biological
and microbiological processes also may be excluded from patentability.
However, the members can protect the plant varieties in any of the following
methods: (i) by patents, or (ii) by an effective subgeneris system (breeder’s
rights), or (iii) by any combination thereof. These provisions shall be reviewed
4 years after January 1, 1995.
6. Integrated Circuits
The TRIPs Agreement provides protection to the layout-designs (topographies)

of integrated circuits. Such protection is allowed for a period of 10 years. However,
the protection shall lapse 15 years after the creation of the layout-design.
7. Trade Secrets
Trade secrets and know-how commercial value shall be protected against

breach of confidence and other acts. Test data submitted to Governments for
obtaining marketing approval in case of pharmaceuticals or agricultural
chemicals shall be protected against unfair commercial use.
This Agreement refers to the controls of anti-competitive practices in

contractual licences relating to intellectual property rights. It provides for
consultations between Governments for protecting intellectual property rights
from being abused.
The Agreement requires transition period to bring their legislation and practices
into conformity for the implementation of TRIPs. Developed countries would
have a one-year transition period, developing countries and the erstwhile East-
European and U.S.S.R. countries would have a 5-year transition period and
the least developed countries 11 years. In case of developing countries, which
do not provide product patent protection have been given 10 years.
The Agreement also envisages the establishment of a Council for Trade Related
Aspects of Intellectual Property Rights for monitoring the operations of the
Agreements and Governments’ compliance with it.
15.2.5 PATENT LAW

In the later part of the nineteenth century new inventions in the field of art,
process, method or manner of manufacture, machinery, apparatuses and
other substances produced by manufacturers were on the increase and the

inventors became very much interested that the inventions done by them
should not be infringed by any one else by copying them or by adopting the
method used by them. To save the interests of inventors the British rulers
enacted the Indian Patents and Designs Act, 1911 (2 of 1911). Since then due
to substantial changes in the political and economic conditions of the country,
it was found desirable to enact comprehensive law on the subject. The Patents
Bill, 1853 was introduced in the Lok Sabha on 7th December 1949 but in lapsed
on the dissolution of the First Lok Sabha. In 1965 the Patents bill, 1965 was
moved in the Parliament but could not be proceeded with for want of time and
eventually lapsed with the dissolution of the Third Lok Sabha. The Patents Bill
was again introduced in the Parliament in 1970. Recently The Patents
(Amendment) Act, 2005 was passed to amend further the Patent Act 1970.
According to the Patents Act, 1970, the term patent means “a patent for any
invention granted under this Act” (Sec. 2 (m)). As per the Act, the term invention
means, “a new product or process involving an inventive step and capable of
industrial application” (Sec.2(j)).
OBJECTS OF THE ACT

The main objectives of patents protection are as follows:
1. Encouraging research and development through invention.

2. Inducing an inventor to disclose his discoveries instead of keeping
them as secret and at the same time giving him the benefits of his
inventions.
3. Offering reward for the expenses incurred in the course of discoveries
and inventions when they are commercially practicable.
4. Providing adequate inducements to invest capital in new lines of
production where the scope of profit will be less, if too many compete
in the same line of production.
Inventions Not Patentable
What are not Inventions (Sec.3)
The following are not inventions within the meaning of this Act.
1. An invention which is frivolous or which claims anything obviously

contrary to well established natural laws.
214 GATT & WTO
2. An invention the primary or intended use or commercial exploitation of

which could be contrary to public order or morality or which causes
serious prejudice to human, animal or plant life or health or to the
environment.
3. The mere discovery of a scientific principle or the formulation of an
abstract theory (or discovery of any living thing or non-living substances
occurring in nature).
4. The mere discovery of a new form of a known substance which does
not result in the enhancement of the known efficacy of the substance
or the mere discovery of any new property or new use for a known
substance or of the mere use of a known process, machine or
apparatus unless such known process results in a new product or
employs at least one new reactant.
5. A substance obtained by a mere admixture resulting only in the
aggregation of the properties of the components thereof or a process
for producing such substance.
6. The mere arrangement or re-arrangement or duplication of known
devices each functioning independently of one another in a known way.
7. A method of agriculture or horticulture.
8. Any process for the medicinal, surgical curative, prophylactic
(diagnostic, therapeutic) or other treatment of human beings or any
process for a similar treatment of animals to render them free of
disease or to increase their economic value or that of their products.
9. Plants and animals in whole or any part thereof other than micro-
organisms but including seeds, varieties and species and essentially
biological processes for production or propagation of plants and
animals.
10. A mathematical or business method or a computer programme per
se or algorithms.
11. A literary, dramatic, musical or artistic work or any other aesthetic
creation whatsoever including cinematographic works and television
productions.
12. A mere scheme or rule or method of performing mental act or method
or playing game.
13. A presentation of information.

14. Topography of integrated circuits.
15. An invention which in effect, is traditional knowledge or which is an
aggregation or duplication of known properties of traditionally known
component or components.
CHECK YOUR PROGRESS
A. State whether the following statement are True or False
1. GATT aims at expansion of international trade.

2. Most favoured nations clause implies that each nation should be treated
as the favoured nation.
3. The Seventh round of GATT was called as Tokyo Round.
4. India is one of the founder member of the WTO.
5. The Trips agreement covers seven categories of intellectual property.
SUMMARY
The GATT was not a statute to be compulsorily enforced on member countries,

but an instrument forged by common consent and adhered to voluntarily by
them. The WTO is the successor to the GATT. The GATT was a forum where
the member countries met once in a decade in order to discuss and solve
world trade problems. The WTO is a permanent organization for world trade.
It has a legal status.
GLOSSARY
Trade marks : Any sign or any combination of signs, capable of distinguishing

the goods or services of one undertaking from those of other undertaking
constitutes a trade mark.
Patent : Patent is a monopoly right, granted by law, to commercial use of an

invention that is new and is useful and that is adequately disclosed.
1. True 2. True 3. True 4. True 5. True

216 GATT & WTO
MODEL QUESTIONS
1. Explain the provisions of the GATT.

2. Discuss the functions of WTO.
3. Write a note on Tokyo Round.
4. What are objectives of WTO?
5. Explain the functions of WTO?
BOOKS FOR REFERENCE

2. D.M.Mithani - International Economics
TAMIL NADU OPEN UNIVERSITY
B.A., ECONOMICS - THIRD YEAR (BEC - 31)
INTERNATIONAL ECONOMICS
Model Question Paper
Time : 3 Hrs Part A Max. Marks: 75
Answer Any THREE Questions (3 x 5 = 15)
1. Briefly discuss the problems of International liquidity.

2. Explain the concept composition of Trade.
3. Describe the different types of terms of Trade.
4. State the functions of SDR.
5. Discuss the growth of MNCs in INdia.
Part B
Answer Any FOUR Questions (4X15=60)
6. What are the objectives of IBRD? and describe the lending operations of IBRD.
. 7. What are the causes of disequilibrium in Balance of payments and how it can
be corrected?
8. Explain the advantages and disadvantages of fixed exchange rate.
9. Explain the meaning of Gains from Trade and measurement of Gains from Trade.
10. What is the difference between inter regional and international made and
explain the advantages of international trade?
11. Explain the Haberlers Theory of opportunity costs.
12. What are the function of WTO and explain the AOA?

Bec-31 Final

Uploaded by

Copyright:

Available Formats

Bec-31 Final

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Bec-31 Final

Uploaded by

Copyright:

Available Formats

B.A.

SCHOOL OF SOCIAL SCIENCES

Prof. M.S. Palanichamy,

Editing & Co-ordination

First Edition: 2007

BLOCK – I INTRODUCTION AND THEORIES OF INTERNATIONAL TRADE

Features and Importance of International Trade – Internal and International trade -

BLOCK – II TERMS OF TRADE AND COMMERCIAL POLICY

BLOCK – III BALANCE OF TRADE AND BALANCE OF PAYMENTS

Balance of trade and balance of payments – Balance of payment always balances –

BLOCK – IV FOREIGN EXCHANGE MARKET AND EXCHANGE CONTROL

Functions and Transactions – Meaning of exchange rate – Determination of exchange

BLOCK – V INTERNATIONAL FINANCIAL INSTITUTIONS AND TRADE

1. D.M.Mithani, International Economics, Himalaya Publishing House, Mumbai.

2. M.L. Jhingan, International Economics, Vrinda Publications (P) Ltd., Delhi.

3. Francis Cherunilam, International Economics, Tata Mc-Graw Hill Publishing

5. Dwivedi, D.N. International Economics, Tamil Nadu Book House Publishers.

BLOCK - I INTRODUCTION AND THEORIES OF PAGE NO.

Unit 1 International trade Vs. Inter Regional trade 2 - 13

Unit 2 Classical theory (Adamsmith) of International Trade 14 - 21

Unit 3 Neo-classical theory (Haberlers theory of opportunity cost) 22 - 42

Unit 4 Modern theory - International trade 43 - 60

Unit 5 Measurement of distribution of gains from trade 61 - 72

BLOCK - II TERMS OF TRADE AND COMMERCIAL POLICY

Unit 6 Trade policy 74 - 81

Unit 7 Quota and Tariff 82 - 89

Unit 8 Terms of Trade 90 - 98

BLOCK - III BALANCE OF TRADE AND BALANCE OF PAYMENTS

Unit 9 Balance of payment 100 - 111

Unit 10 Foreign trade 112 - 132

BLOCK - IV FOREIGN EXCHANGE MARKET AND

Unit 11 Foreign exchange 134 - 150

BLOCK - V INTERNATIONAL FINANCIAL INSTITUTION AND

Unit 14 World bank and India 178 - 191

Unit 15 GATT & WTO 192 - 216

INTRODUCTION AND THEORIES OF INTERNATIONAL TRADE

Unit 1 : International trade Vs Inter Regional trade

Unit 2 : Classical Theory of International trade (Adamsmith)

Unit 4 : Modern theory International trade

Unit 5 : Measurement of distribution of gains from trade

After studying this unit you will be able to

Ø explain the meaning of International trade

1.1 THEORY OF INTERNATIONAL TRADE

1.1.1 MEANING OF INTER REGIONAL TRADE

1.1.2 MEANING OF INTERNATIONAL TRADE

1.1.3 DIFFERENCE BETWEEN INTER REGIONAL TRADE AND

1. Internal and domestic trade refers to the exchange of goods and

2. Expansion of Production over and above the Domestic Requirements :

3. Meeting tough competition in the home country : Concerns that face

4. Inadequate scope in Home Market : If the scope in home market is

5. Political Instability : Political instability is another reason, which makes

6. Ample Scope for advanced technology and Managerial Competence :

7. Liberalization and Globalization : Mostly, countries, all over the world

1.1.5 FEATURES OF INTERNATIONAL TRADE

1. Immobility of Resources : Various factors of production such as labour,

5. Different political groups : Another important feature of international trade

6. Geographical and climatic differences : Each country cannot produce

7. Problem of Balance of Payments : The problem of balance of payments