Open Economy

--International Trade
--Exchange Rate
--Balance of Payments
International Trade
Domestic Trade: Trade within the country.

International Trade: The exchange of goods and services

between countries and across borders is referred to
as international trade.
Advantages of International Trade:
1. Specialization: Each nation or region to specialize in the
production of those goods for which their factor equipment is
most suited.
2. Availability and cheapness of commodities: Because
of international trade the consumers can get access to foreign
goods at lower prices.
3. Development of backward nations: Under-developed
countries are able to import machinery and capital goods in
exchange for their raw materials, agricultural products and
food stuffs.
4. Reduces monopolistic exploitation
5. Stabilization of internal price: the surpluses of the country
could be exported to the other country and the deficits of one
country may be made up by imports. This will ultimately lead to
stabilization of internal price level.
6. International Relationship
7. Poor and backward nations can become rich and forward:
OPEC (Organization of the Petroleum Exporting Countries)
nations become worlds richest nations due to trade only.
Theories of International Trade:
1. Absolute Cost Advantages:
2. Comparative Cost advantages:
Assumptions of the theory
3. Two Countries
4. Two Commodities
5. No Transport Cost
6. The Only element of cost of production is labour
7. Cost is measured based on units of labour required to
produce
1. Absolute Cost Advantages:
• An absolute advantages refers to the ability of a country to
produce a commodity most cost effectively than other
country.
• A country can produce more quantity with same cost in
comparison to other country
• Or Same quantity can be produced with less cost in
comparison to other country
Absolute Cost Difference
Units of Labour Required to Produce 1 unit of product
Country Wheat Cloth Domestic Exchange
(Cost in (Cost in labour Rate
labour units) units)
India 40 (a1) 80 (b1) 1 wheat = 0.5 Cloth
UK 80 (a2) 40 (b2) 1 wheat = 2 Cloth
 India has absolute cost advantages on Wheat because India needs less labour
to produce wheat in comparison to UK
 UK has absolute cost advantages on Cloth because UK needs less labour to
produce cloth in comparison to India.
 India will export Wheat to UK
 Where as UK will export Cloth to India
2. Comparative Cost Advantages
 When a country has absolute advantages over the other
country in terms of both the products
 It will be beneficial for it to specialise in that commodity in
which it enjoys comparative advantages
 It will be beneficial for the other country to produce that
commodity in which comparative disadvantages less
Comparative Cost advantages
Units of Labour required to produce 1 unit
Country Wheat Cloth Domestic Exchange
Rate
India 40 (a1) 80 (b1) 1 wheat = 0.5 Cloth
UK 90 (a2) 100 (b2) 1 wheat =0.9 Cloth

 Here India has an absolute advantages in both Wheat & Cloth

 India has comparatively more cost advantages in producing Wheat
 UK has less comparatively disadvantages of producing Cloth
 India will export wheat to UK
 UK will export cloth to India
 Both the countries will be benefited
 Free Trade Vs. Protection
Free Trade: Free & unrestricted movement of goods
between countries.
• Absence of Govt. control on trade
• No Trade tariffs & quotas
Protection: Protection means protecting the home
industries from foreign competition.
• Protection refers to giving subsidies to home industries and
• Imposing tariffs on the foreign goods by raising their price in
comparison to home produced goods
 Methods of Protection or Trade Barriers:
Tariffs: Tariff or import duty is a tax on imports
Anti-dumping duty is imposed to protect local businesses and markets from
unfair competition by foreign imports
Non-Tariff Protections:
1. Import Quotas: fixing the import quantity
2. Boycott of Foreign Goods
3. Subsidies: Financial help given by the govt. to the domestic producers to
make them more competitive in international market. Domestic price
decreases due to more subsidies.
4. Devaluation: Officially lowering the value of rupee by RBI to increase export &
decrease import. Exports will increase and imports will decrease due
to exports becoming cheaper and imports more expensive.
5. Import License: Govt. may restrict the import license to few
business unit.
6. Voluntary Export Restraint: a trade restriction on the quantity of a
good that an exporting country is allowed to export to another
country. This limit is self-imposed by the exporting country.
7. Strict Customs & Entry procedure: Documentation, Permits,
Inspection, quality check are often used to hinder free flow of trade
8. Embargo: An embargo is a government order that restricts
commerce with a specified country or the exchange of specific goods.
Fiscal Policy Effect on Net Export
Expansionary Fiscal Policy:
 Govt. Spending rises & Tax burden reduces on public
 Aggregate Demand rises due to more consumption and govt. spendings
 Domestic Price rises/ inflation rises
 When domestic price rises, export decreases and import increases.
 Net export decreases
Contractionary Fiscal Policy:
 Govt. Spending decreases & Tax burden rises
 Aggregate Demand decreases
 Domestic Price Decreases
 Export rises & import decreases
 Net Export increases
World Trade Organization (WTO)
WTO has emerged as a world’s most powerful institutions for reducing trade
related barriers between the countries and opening new markets.
• Created in 1948
• 164 member countries including India
Role of WTO in international business
1. WTO facilitates implementation, administration and smooth operations of
trade agreements between the countries.
2. It provides a forum for the trade negotiations between its member countries.
3. Settlements of disputes between the member countries through the
established rules and regulations.
4. It cooperates with the IMF(International Monitory Fund) and World Bank in
terms of making cohesiveness in making global economic policies.
 Trade barriers
Impact on
Price, Output, and Income.
• Govt. imposes more tariffs on import: Due to this import Price rises
• More subsidies for domestic industries: This decreases domestic
price
• Demand for domestic product rises due to higher import price and
low domestic price.
• Employment, output & national income rises
 Exchange Rate
The rate at which one currency is exchanged for another currency.
1 USD = 74 INR
Types of Exchange Rate:
1. Fixed Exchange Rate
2. Floating Exchange Rate
3. Managed floating Exchange Rate
Fixed Exchange Rate (Pegged Rate): A fixed exchange rate is a
regime applied by a government or central bank that ties the country's
official currency exchange rate to another country's currency or the price of
gold.
• Fixed exchange-rates are not permitted to fluctuate freely or respond to
daily changes in demand and supply. 
• The government or central bank fixes the exchange value of the currency.
• For example, the RBI may fix its exchange rate at $1=Rs. 70 
• Most of the countries followed Fixed rate before 1972
Bretton wood system: It is a fixed exchange rate system where all the
currencies are pegged to USD & USD is pegged to Gold price.
Gold Standard: The Gold Standard was a system under which nearly all
countries fixed the value of their currencies in terms of a specified amount
of gold.
Floating Exchange Rate: A floating exchange rate is a regime where
the exchange rate is determined by Demand & Supply in Foreign Exchange
Market.
Supply of Dollar: Sources of supply of Dollar
• Exporter receives Dollar
• Foreign investors investing in India
• Foreign Tourists travelling in India
• Those who are working outside
• Foreign Aids
Demand for dollar: Sources of Demand for Dollar
• Importers need dollar to pay
• Indians investing in outside
• Foreign portfolio investors selling shares
• Travelling to other countries
Daily Fluctuations of Exchange Rate
Export & Supply of Demand Dollar Rupee Exchange
Import Dollar for Dollar Value Value Rate
USD to
Rupee

Export Increases - Depreciates Appreciates Decreases

Increases
Export Decreases - Appreciates Depreciates Increases
Decreases
Import - Increases Appreciates Depreciates Increases
Increases
Import - Decreases Depreciates Appreciates Decreases
Decreases
Managed Floating Rate: A managed floating exchange rate is
a regime that allows the central bank to intervene the foreign
exchange market.
 Exchange rate is decided based on Demand and Supply
 RBI intervene when it moves out of comfort zone
 It is a market oriented exchange rate + Intervention
 Some times RBI officially devaluate the currency to encourage export.
 RBI buys Dollar, So that the supply of dollar decreases & value of
dollar increases and value of rupee devaluates
 India follows managed floating rate since 1994
Note: Rupee Depreciation means automatically the value decreases based on demand and supply. Devaluation
means RBI officially decreases the value of rupee by reducing the dollar in the market
 Nominal & Real Exchange Rate
Nominal Exchange Rate (NER): The nominal exchange rate tells
how much domestic currency can be exchanged for an unit of
foreign currency.
• Nominal exchange rate (USD to INR): 1USD = 70 INR
• Nominal exchange rate (INR to USD): 1 INR = 0.014 USD
Real Exchange Rate (RER):  
How much the goods in the domestic country can
be exchanged for the same goods in a foreign country.
The real exchange rate can be defined as the nominal exchange
rate that takes the inflation differentials among the countries into
account.
How many Indian Burgers can be exchanged with one unit of USA
burger? This is Real Exchange Rate.
When Nominal Exchange Rate (NER): USD to INR = 70
RER = Nominal Exchange Rate (NER) x

When Nominal Exchange Rate (NER) : INR to USD= 0.014

RER = Nominal Exchange Rate (NER) x
Burger Price in USA = 1 USD
Burger Price in India = Rs. 140
Nominal Exchange Rate (NER) = Rs.70
RER = Nominal Exchange Rate (NER) x
RER = 70 x = 70 x = = = 0.5

RER = 0.5 , Means 0.5 units of Indian burger can be exchanged for 1 unit of USA
Burger.

Actual RER formula

RER = Nominal Exchange Rate (NER) x
Effective Exchange Rate
The real effective exchange rate (REER) is the weighted
average of a country's currency in relation to an index or
basket of other major currencies. 
Here instead of 1 countries price, we are considering
weighted average price of many countries price.
Fixed exchange Rate: Advantages
 Promotes Trade: Providing greater certainty for importers and exporters in
terms of payments, therefore encouraging more international trade.
 Promotes international investment: If the exchange rate fluctuates
the investors will not be prepared to lend for long term investments.
 Price stability: Due to fixed exchange rate the price is more or
less stable. Incase of floating exchange rate, currency depreciates and
appreciates. When the currency value depreciates, export rises, import falls, so
the demand for the domestic product rises and price rises.
Fixed Exchange Rate: Disadvantages
1. Problem for trade deficit
IN case of trade deficit, RBI use to devaluate the rupee so that
export will increase and import will decrease. Trade deficit
narrows. Due to fixed exchange rate central bank can not
adjust the exchange rate officially to influence trade.
Floating exchange Rate: Advantages
1. Automatic correction of Trade Deficits: when the trade deficit rises
means export decreases and import increases. The supply of dollar
decreases due to less export and demand for dollar rises due to more
import. Dollar value appreciates & rupee value depreciates
automatically. When rupee value depreciates export again rises and
import decreases. Trade deficit narrows.
2. RBI can influence the economy by influencing the exchange rate.
When RBI devaluates currency, export demand for Indian product
rises, as a result employment, output and income rises.
3. Complete freedom to Central Bank
Floating Exchange Rate: Disadvantages
1. Uncertainty:  A seller may not be quite sure of how much
money he will receive when he sells goods abroad due to
exchange rate fluctuations. It affects trade.
2. Lack of Investment: The uncertainty introduced by
floating exchange rates may discourage direct foreign investment
(i.e., investment by multi­national companies) and foreign
portfolio investment.
3. Speculation: it will encourage speculation activities in
foreign exchange market. Which make more volatile.
Factors Influencing the Exchange Rate:
1. Export & Import: Due to change in export and import the supply and
demand for foreign currency changes.
2. Capital Flow: when the capital inflows to India, supply of dollar rises
and dollar value depreciates & rupee increases
3. Foreign Loans: Supply of dollar rises
4. Sale and purchase of securities: When foreign investors sell
securities, demand for dollar rises & dollar value appreciates, rupee
decreases. When foreign investors purchases securities supply of dollar
rises, dollar value decreases & rupee rises
5. Trade protection: When govt restricts import, the demand for dollar
decreases, Dollar value decreases & rupee value rises
6. Inflation and Deflation: During inflation export decreases, supply of
dollar decreases, dollar value increases & rupee value decreases. And during
deflation export rises, supply of dollar rises, dollar value depreciates and rupee
value appreciates.
7. Fiscal & Monetary policy: due to both the policies aggregate demand
and domestic price changes. As a result it affects export and import & exchange
rate.
8. Interest rate: If the domestic interest rate is higher in comparison to world
rate, foreign investors invest in India for higher return. As a result supply of dollar
rises, dollar value depreciates and rupee appreciates
9. Political Uncertainty: it affects inflow of foreign investment to India
10. Speculation: Speculators buy and sell the foreign currencies to make
profit if the value rises in future
Exchange Rate & Trade deficits
Currency appreciation: When rupee value appreciates, export
decreases & import rises. Trade deficit widens
Currency Depreciation or Devaluation: When rupee value
decreases, Export becomes cheaper and import becomes
dearer. Export rises & import falls. Trade deficit narrows.
Effects of exchange rate on prices & output
Appreciation of Exchange Rate: when exchange rate
appreciates, Dollar value decreases, It will decrease the demand for
domestic products, decreasing domestic output and price.

Depreciation of Exchange Rate: when exchange rate

appreciates, Dollar value increases, It will increase the demand for
domestic products, increasing domestic output and price.
Participants in Foreign Exchange Market
1. Brokers-Banks
2. Central Bank
3. Financial Institutions
4. Individuals
5. Businessman
6. Tourists
7. IMF & World Bank
Balance of Payments
Balance of Payments: It is a systematic record of all the economic
transactions between one country and the rest of the world during a year
 It is a financial statement of payments and receipts on international
transaction
 It includes all the transactions, Visible (Merchandise goods), invisible
(Services) & Capital flows
 It is a double entry book-keeping system
 It has two sides: Credit & Debit
 Receipts from rest of world are recorded in credit side
 Payments made to rest of world recorded in debit side
 When money is going out from India for any purposes, it is a debit item
 When money is coming to India for any purposes, is a credit item
 Even the loan is coming to India is a credit item.
Balance of Payments Equilibrium:
Total Payments (Debit) = Total Receipts(Credit)
Balance of Payments Deficit:
Total Payments > Total Receipts
Balance of payments Surplus:
Total Receipts > Total Payments
 In Accounting sense Balance of payments is always equilibrium
 Total credits & debits always balance each other
Balance of Payments & Balance of Trade
Balance of Trade: It includes only transaction (export & import)
of visible items (Merchandise Goods only)
Balance of payments: It includes all the items: Visible items
(Merchandise goods), invisible items (services: Banking, transport,
insurance) & Capital flows (Loans & investment) etc

Balance of Trade is favourable : The value of export of visible items

(goods) exceeds the value of import of visible items (goods).
Visible Items: Goods or Merchandise
Ex: Export and import of CAR, Mobile, Agricultural Products, Food items

Invisible Items: Services or Non Merchandise

Ex: Transportation services (Warehousing + Transit expenses). Our country pays for using the foreign
transportation services & foreign countries pays to India for using our services in India. When we pay it comes
into debit A/C. When foreigners pay it comes to credit A/C.
EX: Tourist expenditure: Expenditure of foreign tourists in India is a credit item & expenditure of our tourists in
outside is a debit item.
EX: Banking services: Using foreign banking services is a debit item & foreigners using our banking services
credit item.
Ex: Govt. Transactions: Salaries paid to our ambassadors & high commissioners are debit items & foreign
countries paid the salaries to their ambassadors working in our country is a credit item.
EX: Factor income from abroad: Indians income coming from abroad is credit & Foreign nationals income going
out is debit
Ex: Unilateral transactions: Donations & gifts to India from others is a credit item. & to other countries from
India is a debit item. It is unilateral because no need to return back or exchange anything for donations and gifts
EX: Investment income: Interest, profits & dividends received by Indian investors from foreign countries are
credit item. Foreigners received from India is debit item.
 Current Account items:
1. Visible items (Merchandise Goods): Export and import of
merchandise goods. Export is credit item & import is debit item. Ex. Food, Electronics,
Textile, Crude oil, Medicines, Raw materials, Capital goods, etc
2. Invisible Items (Services): Foreign services used by our country is a
debit item bcz we are paying & Other countries used by our services are credit items
bcz we receive.
a. Travel (tourist expenses)
b. Transportation
c. Banking & insurance services
d. Income on foreign investment (Interest, Profits etc)
e. Govt. transactions on official expenditure
f. Unilateral transactions: Donations, Gifts, Foreign aids, Grants
g. Miscellaneous ( advertisement, patent fees, etc)
 Capital Account Items:
The capital account deals with financial transactions. It includes short-term and long-term capital
movement & official Gold transactions.
The capital account keeps track of the net change in a nation's assets and liabilities during a year.
Private loans: Foreign loans received by Indian firms (credit). Loans repaid by Indian firms (debit)
Banking Capital: inflow of banking capital excluding (RBI) (credit). Outflow of banking capital(debit)
FDI & FPI: FDI & FPI inflow (credit) and outflow (debit)
Official (Govt) Capital Transaction
(i) Loans: Loans received by official sector from foreign countries (Credit). Loans extended to other
countries (debit)
(ii)IMF drawings (SDR): received drawings (SDR) from IMF (credit). Repurchase/repayment of
drawings to IMF (debit)
(iii)Amortisation: Repayments of official loans by India to other countries (debit item). Repayments of
loans by other countries to India is (credit item):
(iv) Foreign exchange reserves & Monetary Gold reserves: The reserves increase in case of a trade
surplus and decrease when there is a trade deficit. RBI imports gold (debit) when trade surplus and
RBI exports gold (credit) when trade deficit.
Trade Deficit: When the value of imports of only visible items
( merchandise goods) exceeds the value of export of only visible items
(merchandise goods)

Current Account Deficit: When the value of imports of both

visible items (material goods) & invisible items (services: Banking,
Insurance, transport etc) exceeds the value of exports of both goods &
services.
Balance of payments deficit: Total debit exceeds total
credit. It includes current Account (Visible + Invisible items), Capital
Account
Is Balance of payments always balance?
In accounting sense balance of payment is always
equilibrium. Because it is a double-entry book keeping.
Debit should be equal to credit.
But actually balance of payment is always disequilibrium. If
there is deficit in current account it will be corrected
through capital account adjustment.
(1) By raising loans from foreign countries
(2) By getting drawings from IMF
(3) Official export of gold
(4) Or by reduction of foreign exchange reserves