Tag: Business economics

Functions of Foreign Exchange Market

1. Transfer Function: Foreign exchange market transfers purchasing power between the countries involved in the transaction.

This function is performed through credit instruments like bills of foreign exchange, bank drafts and telephonic transfers.

2. Credit Function: Foreign exchange market provides credit for foreign trade.

Bills of exchange, with maturity period of three months, are generally used for international payments.

Thus, credit is required for this period to enable the importer to take possession of goods, sell them and obtain money to pay off the bill.

3. Hedging Functions: Hedging in an important function of foreign exchange market.

When exporter and importers enter into an agreement to sell and buy gods on some future date at the current prices and exchange rate, it is called hedging.

Fixed exchange rate system:

The system in which the foreign exchange rate is officially fixed by the government/monetary authority and not determined by markets forces.

Under fixed exchange rate system: Each country keeps the value of its currency fixed in terms of some external standard.

This external standard can be gold, silver, other precious metal, another country’s currency, or even some internationally agreed unit of account.

In earlier times, exchange rates of all major countries were fixed according to the Gold Standard.

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime in which a currency’s value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold.

There are benefits and risks to using a fixed exchange rate system. A fixed exchange rate is typically used to stabilize the exchange rate of a currency by directly fixing its value in a predetermined ratio to a different, more stable, or more internationally prevalent currency (or currencies) to which the currency is pegged. In doing so, the exchange rate between the currency and its peg does not change based on market conditions, unlike in a floating (flexible) exchange regime. This makes trade and investments between the two currency areas easier and more predictable and is especially useful for small economies that borrow primarily in foreign currency and in which external trade forms a large part of their GDP.

Merits:

(i) It ensures stability in exchange rate which encourages foreign trade.

(ii) It contributes to the coordination of macro policies of countries in an interdependent world economy.

(iii) Fixed exchange rates prevents capital outflow.

(iv) It prevents speculation in foreign exchange market.

(v) Fixed exchange rates are more conductive to expansion of world trade because it prevents risk and uncertainty in transactions.

Demerits:

(i) There is a fear of devaluation in situation of excess demand.

Central Bank uses its reserves to maintain fixed exchange rate.

But when reserves are exhausted and excess demand still persists, government is compelled to devalue domestic currency.

If speculators believe the exchange rate cannot be held for log, they buy foreign exchange in massive amount causing deficit in BOP. This may lead to larger devaluation.

This is the main flaw of fixed exchange rate system.

(ii) Benefits of free markets are deprived.

(iii) There is always possibility of undervaluation or overvaluation.

Disadvantages of Fixed Exchange Rate

Developing economies commonly use a fixed rate structure to curb inflation and provide a stable system. A secure environment enables importers, exporters, and investors to plan without having to worry about currency movements.

A fixed-rate structure, however, limits the ability of a central bank to change interest rates as required for boosting economic growth. Often, a fixed rate system prevents market fluctuations when a currency is over or undervalued. Effective management of a fixed-rate system also needs a large pool of reserves, when it is under pressure, to support the currency.

An unsustainable official exchange rate can also trigger a parallel, unofficial, or dual exchange rate to grow. A large gap between official and unofficial rates will draw hard currency away from the central bank, which can result in shortages of forex and periodic devaluations. These can be more detrimental for an economy than the daily adjustment of a floating currency regime.

Flexible (fixating) Exchange Rate:

Flexible exchange rate is the rate which is determined by forces of supply and demand in the foreign exchange market. There is no official (govt.) Intervention. Here the value of a currency is left completely free to be determined by market forces of demand and supply of foreign exchange.

In macroeconomics and economic policy, a floating exchange rate (also known as a fluctuating or flexible exchange rate) is a type of exchange rate regime in which a currency’s value is allowed to fluctuate in response to foreign exchange market events. A currency that uses a floating exchange rate is known as a floating currency, in contrast to a fixed currency, the value of which is instead specified in terms of material goods, another currency, or a set of currencies (the idea of the last being to reduce currency fluctuations).

In the modern world, most of the world’s currencies are floating, and include the most widely traded currencies: the United States dollar, the euro, the Swiss franc, the Indian rupee, the pound sterling, the Japanese yen, and the Australian dollar. However, even with floating currencies, central banks often participate in markets to attempt to influence the value of floating exchange rates. The Canadian dollar most closely resembles a pure floating currency because the Canadian national bank has not interfered with its price since it officially stopped doing so during 1998. The US dollar is a close second, with very little change of its foreign reserves. By contrast, Japan and the UK intervene to a greater extent, and India has medium-range intervention by its national bank, the Reserve Bank of India

Merits:

(i) Deficit or surplus in BOP is automatically corrected.

(ii) There is no need for government to hold any foreign reserve.

(iii) It helps in optimum resource allocation.

(iv) It frees the government from problem of balance of payment.

(v) Flexible exchange rate increases the efficiency in the economy by achieving best allocation of resources.

Demerits:

(i) It encourages speculation leading to fluctuation in exchange rate.

(ii) Wide fluctuations in exchange rate can hamper foreign trade and capital movement between countries.

(iii) It generates inflationary pressure when prices of imports go up due to depreciation of the  currency caused by deficit in BOP.

(iv) It discourages investment and international trade.

Determination of Exchange Rate (Flexible Exchange Rate System)

Rate of exchange is determined by the interaction of then force of demand and supply.

let us understand the various sources of demand and supply of foreign exchange.

Demand for Foreign Exchange Demand (outflow) for foreign exchange arises due to the following reasons

1. Import of Goods and Services: foreign exchange is demanded to make the payment for imports of goods and services.
2. Tourism: When Indian tourists go abroad, they need to have foreign currency with them to meet their expenditure abroad. So, foreign exchange is needed to undertake foreign tour.

3. Unilateral Transfers sent abroad: Foreign exchange is required for making unilateral transfers like sending gifts to other countries.
4. Purchase of Assets in Foreign Countries: Foreign exchange in needed to make payment for the purchase of assets (like land, building, share, bonds etc.) in foreign countries.
5. Speculation: Demand for foreign exchange arises when people want to make gains from appreciation of the currency.

Managed floating rate system refers to a system in which foreign exchange rate is determined by market force and central bank is a key participant to stabilize the currency in case of extreme, appreciation or depreciation.

Under Managed floating rate system, also called dirty floating, central banks to buy and sell foreign currencies in an attempt to moderate exchange rate movement whenever they feel that such actions are appropriate.

Against the two extremes of rigidly fixed and freely flexible exchange rates, a system of controlled or managed flexibility is suggested on practical considerations into the exchange rate regime.

The focus on intermediate regime between fixed and floating exchange rate is desirable for a prudency to eliminate the drawbacks and capture the advantages of both extreme systems.

Under the managed or controlled flexibility of exchange rate system, the scope of the range of flexibility around fixed par values is determined by the country as per its economic need and the prevailing trend in the international monetary system.

Managed floating exchange rate system is essentially based on the par value concept under the IMF guidelines.

Managing or controlling exchange rates requires the country to intervene in the foreign exchange market time to time in view of the emerging BOP disequilibrium.

Categories

1. Adjustable Peg System:

Under the Bretton Woods System, the exchange rates of different currencies were pegged in terms of gold or the U.S. dollar at the rate of $ 35 per ounce of gold. The nations were allowed to change the par values of their currencies when faced with a ‘fundamental’ disequilibrium.

2. Crawling Peg System:

The crawling peg system was popularised in mid-sixties by such prominent economists as William Fellner, J.H. Williamson, J. Black, J.E. Meade and C.J. Murphy. This system is a compromise between the extremes of freely fluctuating exchange rates and perfectly stable exchange rates. It was devised in order to avoid the disadvantage of relatively large changes in par values and possibly destabilising speculation associated with the system of adjustable peg.

In case of the Bretton Woods adjustable peg, sudden and large changes in exchange rates have to be made. These are clearly undesirable and should be avoided.

3. Policy of Managed Floating:

The exchange rates may continue to fluctuate, even if speculation is stabilising, on account of the variations that take place in the real sectors of the economy. The fluctuations in exchange rate tend to have an adverse effect upon the flow of international trade and investments. The Smithsonian Agreement made on December 18, 1971 provided for the widening of margin of fluctuations from 1 percent on each side of the exchange parity to 2.25 percent on each side of the par value of exchange.

Clean and Dirty Float Systems:

In connection with a system of managed float, it may be pointed out that a distinction is sometimes made between a clean float and dirty float.

(i) Clean Float:

In case of clean float, the rate of exchange is allowed to be determined by the free market forces of demand and supply of foreign exchange. The exchange rate is permitted to move up and down. The foreign exchange market itself corrects the excess demand or excess supply conditions without the intervention of monetary authority. Thus, the policy of clean float is identical to the policy of freely fluctuating exchange rates.

(ii) Dirty Float:

In case of a dirty float, the exchange rate is sought to be determined by the market forces of demand and supply for foreign exchange. However, the monetary authority intervenes in the foreign exchange market through the pegging operations either to smoothen or to eliminate the fluctuations altogether. It means even the long term trend in exchange rate is manipulated by the monetary authority. Such a policy of managed float is understood as the policy of ‘dirty float’.

Foreign direct investment (FDI) is an investment from a party in one country into a business or corporation in another country with the intention of establishing a lasting interest. Lasting interest differentiates FDI from foreign portfolio investments, where investors passively hold securities from a foreign country. A foreign direct investment can be made by obtaining a lasting interest or by expanding one’s business into a foreign country.

Foreign investment involves capital flows from one country to another, granting the foreign investors extensive ownership stakes in domestic companies and assets. Foreign investment denotes that foreigners have an active role in management as a part of their investment or an equity stake large enough to enable the foreign investor to influence business strategy. A modern trend leans toward globalization, where multinational firms have investments in a variety of countries.

Benefits of Foreign Direct Investment

Foreign direct investment offers advantages to both the investor and the foreign host country. These incentives encourage both parties to engage in and allow FDI.

• Market diversification
• Tax incentives
• Lower labor costs
• Preferential tariffs
• Subsidies

Disadvantages of Foreign Direct Investment

• Displacement of local businesses
• Profit repatriation

The entry of large firms, such as Walmart, may displace local businesses. Walmart is often criticized for driving out local businesses that cannot compete with its lower prices.

Advantages of Foreign Direct Investment.

1. Economic Development Stimulation

Foreign direct investment can stimulate the target country’s economic development, creating a more conducive environment for you as the investor and benefits for the local industry.

2. Easy International Trade

Commonly, a country has its own import tariff, and this is one of the reasons why trading with it is quite difficult. Also, there are industries that usually require their presence in the international markets to ensure their sales and goals will be completely met. With FDI, all these will be made easier.

3. Employment and Economic Boost

Foreign direct investment creates new jobs, as investors build new companies in the target country, create new opportunities. This leads to an increase in income and more buying power to the people, which in turn leads to an economic boost.

4. Development of Human Capital Resources

One big advantage brought about by FDI is the development of human capital resources, which is also often understated as it is not immediately apparent. Human capital is the competence and knowledge of those able to perform labor, more known to us as the workforce. The attributes gained by training and sharing experience would increase the education and overall human capital of a country. Its resource is not a tangible asset that is owned by companies, but instead something that is on loan. With this in mind, a country with FDI can benefit greatly by developing its human resources while maintaining ownership.

5. Tax Incentives

Parent enterprises would also provide foreign direct investment to get additional expertise, technology and products. As the foreign investor, you can receive tax incentives that will be highly useful in your selected field of business.

6. Resource Transfer

Foreign direct investment will allow resource transfer and other exchanges of knowledge, where various countries are given access to new technologies and skills.

Disadvantages of Foreign Direct Investment

Hindrance to Domestic Investment.

As it focuses its resources elsewhere other than the investor’s home country, foreign direct investment can sometimes hinder domestic investment.

Risk from Political Changes.

Because political issues in other countries can instantly change, foreign direct investment is very risky. Plus, most of the risk factors that you are going to experience are extremely high.

Negative Influence on Exchange Rates.

Foreign direct investments can occasionally affect exchange rates to the advantage of one country and the detriment of another.

Higher Costs.

If you invest in some foreign countries, you might notice that it is more expensive than when you export goods. So, it is very imperative to prepare sufficient money to set up your operations.

Economic Non-Viability.

Considering that foreign direct investments may be capital-intensive from the point of view of the investor, it can sometimes be very risky or economically non-viable.

Expropriation.

Remember that political changes can also lead to expropriation, which is a scenario where the government will have control over your property and assets.

In an economic model, agents have a comparative advantage over others in producing a particular good if they can produce that good at a lower relative opportunity cost or autarky price, i.e. at a lower relative marginal cost prior to trade. Comparative advantage describes the economic reality of the work gains from trade for individuals, firms, or nations, which arise from differences in their factor endowments or technological progress. (One should not compare the monetary costs of production or even the resource costs (labor needed per unit of output) of production. Instead, one must compare the opportunity costs of producing goods across countries.

David Ricardo believed that the international trade is governed by the comparative cost advantage rather than the absolute cost advantage. A country will specialise in that line of production in which it has a greater relative or comparative advantage in costs than other countries and will depend upon imports from abroad of all such commodities in which it has relative cost disadvantage.

Suppose India produces computers and rice at a high cost while Japan produces both the commodities at a low cost. It does not mean that Japan will specialise in both rice and computers and India will have nothing to export. If Japan can produce rice at a relatively lesser cost than computers, it will decide to specialise in the production and export of computers and India, which has less comparative cost disadvantage in the production of rice than computers will decide to specialise in the production of rice and export it to Japan in exchange of computers.

David Ricardo developed the classical theory of comparative advantage in 1817 to explain why countries engage in international trade even when one country’s workers are more efficient at producing every single good than workers in other countries. He demonstrated that if two countries capable of producing two commodities engage in the free market, then each country will increase its overall consumption by exporting the good for which it has a comparative advantage while importing the other good, provided that there exist differences in labor productivity between both countries. Widely regarded as one of the most powerful yet counter-intuitive insights in economics, Ricardo’s theory implies that comparative advantage rather than absolute advantage is responsible for much of international trade.

Assumption’s

(i) There is no intervention by the government in economic system.

(ii) Perfect competition exists both in the commodity and factor markets.

(iii) There are static conditions in the economy. It implies that factors supplies, techniques of production and tastes and preferences are given and constant.

(iv) Production function is homogeneous of the first degree. It implies that output changes exactly in the same ratio in which the factor inputs are varied. In other words, production is governed by constant returns to scale.

(v) Labour is the only factor of production and the cost of producing a commodity is expressed in labour units.

(vi) Labour is perfectly mobile within the country but perfectly immobile among different countries.

(vii) Transport costs are absent so that production cost, measured in terms of labour input alone, determines the cost of producing a given commodity.

(viii) There are only two commodities to be exchanged between the two countries.

(ix) Money is non-existent and prices of different goods are measured by their real cost of production.

(x) There is full employment of resources in both the countries.

(xi) Trade between two countries takes place on the basis of barter.

Two-commodity model can be analysed through the Table.

Table Labour cost of Production
Country	Labour cost per unit of commodity in Man-Hours
	Commodity X	Commodity Y
A	12	10
B	16	12

The Table indicates that country A has an absolute advantage in producing both the commodities through smaller inputs of labour than in country B. In relative terms, however, country A has comparative advantage in specialising in the production and export of commodity X while country B will specialise in the production and export of commodity Y.

In country A, domestic exchange ratio between X and Y is 12 : 10, i.e., 1 unit of X = 12/10 or 1.20 units of Y. Alternatively, 1 unit of Y= 10/12 or 0.83 units of X.

In country B, the domestic exchange ratio is 16 : 12, i.e., 1 unit of X = 16/12 or 1.33 units of Y. Alternatively, 1 unit of Y = 16/12 or 0.75 unit of X.

From the above cost ratios, it follows that country A has comparative cost advantage in the production of X and B has comparatively lesser cost disadvantage in the production of Y.

In algebraic terms, let labour cost of producing X-commodity in country A is a1 and in country B is a2. The labour cost of producing Y-commodity in countries A and B are respectively a3 and a4.

The absolute differences in costs can be measured as:

a1/a2 < 1 < a3/a4

It shows that country A has absolute advantage in producing X and country B has an absolute advantage in commodity Y.

The comparative differences in costs can be measured as:

a1/a2 < a3/a4 < 1

The Table satisfies the condition specified for comparative difference in costs;

a1/a2 < 1 < a3/a4 < 1

12/16 < 10/12 < 1

In case a1/a2 = a3/a4, there are equal differences in costs and there is no possibility of trade between the two countries.

In Fig. 2.2, AA1 and BB1 are the production possibility curves pertaining to countries A and B. Given the same number of productive resources, A can produce larger quantities of both the commodities than the country B. It means country A has absolute cost advantage over B in respect of both the commodities.

If the curve BC1 is drawn parallel to AA1; the curve BC1 can represent the production possibility curve of country A. If country A gives up OB quantity of Y and diverts resources to the production of X, it can produce OC1 quantity of X, which is more than OB1. It means the country A has comparative cost advantage in the production of X-commodity.

From the point of view of B, it can produce the same quantity OB of Y, if it gives up the production of smaller quantity OB1 of X. If signifies that country B has less comparative disadvantage in the production of Y commodity. Accordingly, country A will specialise in the production and export of X commodity, while country B will specialise in the production and export of Y-commodity.

Gain from Trade:

The comparative cost principle underlines the fact that two countries will stand to gain through trade so long as the cost ratios for two countries are not equal. On the basis of Table , country A specialises in the production of X commodity, while country B specialises in the production of Y commodity.

In the absence of international trade, the domestic exchange ratio between X and Y commodities in these two countries are:

Country A: 1 unit of X = 12/10 or 1-20 units of Y

Country B: 1 unit of Y = 12/16 or 0-75 unit of X

If trade takes place and two countries agree to exchange 1 unit of X for 1 unit of Y, the gain from trade for country A amounts to 0.20 units of Y for each unit of X. In case of country B, the gain from trade amounts to 0.25 unit of X for each unit of Y. Thus the comparative costs principle confers gain upon both the countries.

A multinational corporation (MNC) is a company that operates in its home country, as well as in other countries around the world. It maintains a central office located in one country, which coordinates the management of all its other offices, such as administrative branches or factories.

Multinational corporations are those large firms which are incorporated in one country but which own, control or manage production and distribution facilities in several countries. Therefore, these multinational corporations are also known as transnational corporations. They transact business in a large number of countries and often operate in diversified business activities. The movements of private foreign capital take place through the medium of these multinational corporations. Thus multinational corporations are important source of foreign direct investment (FDI).

Besides, it is through multinational corporations that modern high technology is transferred to the developing countries. The important question about multinational corporations is why they exist. The multinational corporations exist because they are highly efficient. Their efficiencies in production and distribution of goods and services arise from internalising certain activities rather than contracting them out to other firms. Managing a firm involves which production and distribution activities it will perform itself and which activities it will contract out to other firms and individuals.

In addition to this basic issue, a big firm may decide to set up and operate business units in other countries to benefit from advantages of location. For examples, it has been found that giant American and European firms set up production units to explore and refine oil in Middle East countries because oil is found there. Similarly, to take advantages of lower labour costs, and not strict environmental standards, multinational corporate firms set up production units in developing countries.

1. Filling Savings Gap: The first important contribution of MNCs is its role in filling the resource gap between targeted or desired investment and domestically mobilized savings. For example, to achieve a 7% growth rate of national output if the required rate of saving is 21% but if the savings that can be domestically mobilised is only 16% then there is a ‘saving gap’ of 5%. If the country can fill this gap with foreign direct investments from the MNCs, it will be in a better position to achieve its target rate of economic growth.
2. Filling Trade Gap: The second contribution relates to filling the foreign exchange or trade gap. An inflow of foreign capital can reduce or even remove the deficit in the balance of payments if the MNCs can generate a net positive flow of export earnings.
3. Filling Revenue Gap: The third important role of MNCs is filling the gap between targeted governmental tax revenues and locally raised taxes. By taxing MNC profits, LDC governments are able to mobilize public financial resources for development projects.
4. Filling Management/Technological Gap: Fourthly, Multinationals not only provide financial resources but they also supply a “package” of needed resources including management experience, entrepreneurial abilities, and technological skills. These can be transferred to their local counterparts by means of training programs and the process of ‘learning by doing’.

Moreover, MNCs bring with them the most sophisticated technological knowledge about production processes while transferring modern machinery and equipment to capital poor LDCs. Such transfers of knowledge, skills, and technology are assumed to be both desirable and productive for the recipient country.

5. Other Beneficial Roles: The MNCs also bring several other benefits to the host country.

(a) The domestic labour may benefit in the form of higher real wages.

(b) The consumers benefit by way of lower prices and better quality products.

(c) Investments by MNCs will also induce more domestic investment. For example, ancillary units can be set up to ‘feed’ the main industries of the MNCs

(d) MNCs expenditures on research and development(R&D), although limited is bound to benefit the host country.

Apart from these there are indirect gains through the realization of external economies.

Role of a Multinational Corporation

1. Very high assets and turnover

To become a multinational corporation, the business must be large and must own a huge amount of assets, both physical and financial. The company’s targets are high, and they are able to generate substantial profits.

2. Network of branches

Multinational companies maintain production and marketing operations in different countries. In each country, the business may oversee multiple offices that function through several branches and subsidiaries.

3. Control

In relation to the previous point, the management of offices in other countries is controlled by one head office located in the home country. Therefore, the source of command is found in the home country.

4. Continued growth

Multinational corporations keep growing. Even as they operate in other countries, they strive to grow their economic size by constantly upgrading and by conducting mergers and acquisitions.

5. Sophisticated technology

When a company goes global, they need to make sure that their investment will grow substantially. In order to achieve substantial growth, they need to make use of capital-intensive technology, especially in their production and marketing activities.

6. Right skills

Multinational companies aim to employ only the best managers, those who are capable of handling large amounts of funds, using advanced technology, managing workers, and running a huge business entity.

7. Forceful marketing and advertising

One of the most effective survival strategies of multinational corporations is spending a great deal of money on marketing and advertising. This is how they are able to sell every product or brand they make.

8. Good quality products

Because they use capital-intensive technology, they are able to produce top-of-the-line products.

The terms of trade refer to the rate at which one country exchanges its goods for the goods of other countries. Thus, terms of trade determine the international values of commodities. Obviously, the terms of trade depend upon the prices of exports a country and the prices of its imports.

When the prices of exports of a country are higher as compared to those of its imports, it would be able to obtain greater quantity of imports for a given amount of its exports. In this case terms of trade are said to be favourable for the country as its share of gain from trade would be relatively larger.

On the contrary, if the prices of its exports are relatively lower than those of its imports, it would get smaller quantity of imported goods for a given quantity of its exports. There­fore, in this case, terms of trade are said to be unfavourable to the country as its share of gain from trade would be relatively smaller. In what follows we first explain the various concepts of the terms of trade and then explain how they are determined.

Types

1. Commodity or Net Barter Terms of Trade:

If one good is considered export good and the other good is supposed import good then “the ratio between prices of exports to price of imports is given the name of net barter terms of trade”. If we include so many goods then the ratio of price index of exports to price index of imports is called net barer terms of trade.

2. Income Terms of Trade:

The income terms of trade allow the capacity to import of a country on the basis of imports.

3. Single Factor Terms of Trade:

Single factor terms of trade show the number of imports which can be obtained against the domestic factor employed in export sector.

4. Double Factor Terms of Trade:

Such terms of trade measures that how much of factors used in export sector could be substituted against how much of factors employed in import sector.

5. Utility Terms of Trade:

The utility terms of trade are presented to explain welfare changes. The utility terms of trade indicate the total amount of gain from trade, as excess of total utility which is obtained from imports over the total sacrifice of utility in surrender of export.

Equation/Formula:

The terms of trade can be expressed in the form of equation as such:

Terms of Trade = Price of Imports and Volume of Imports/Price of Exports and Volume of Exports

The terms of trade are of economic significance to a country. If they are favorable to a country, it will be gaining more from international trade and if they are unfavorable, the loss will be occurring to it. When the country’s goods are in high demand from abroad, i.e., when its terms of trade are favorable, the level of money income increases. Conversely, when the terms of trade are unfavorable, the level of money income falls.

Measurement of Change in Terms of Trade:

 The changes in terms of trade can be measured by the use of an import and export index number. We here take only standardized goods which have internal market and give them weight according to their importance in the international transactions. A certain year is taken as base year and the average of the countries import and export prices of the base year is called 100. We then work out the index of subsequent year. These indices then show as to how the commodity terms of trade move between two countries. The ratio of exchange in export prices to the change in import prices is put in the form of an equation as under:

Commodity Terms of Trade = Change in Export Prices/Change in Import Price

Concepts of Terms of Trade:

Net Barter Terms of Trade:

The most widely used concept of the terms of trade is what has been caned the net barker terms of trade which refers to the relation between prices of exports and prices of imports. In symbolic terms:

T_n = P_x/P_m

Were

T_n stands for net barter terms of trade.

P_x stands for price of exports (x),

P_m stands for price of imports (m).

When we want to know the changes in net barter tends of trade over a period of time, we prepare the price index numbers of exports and imports by choosing a certain appropriate base year and obtain the following ratio:

Px₁/ Pm₁ : Px₀/ Pm₀

Px„ Pm„

where Px_o and Pm₀ stand for price index numbers of exports and imports in the base year re­spectively, and Px₁) and Pm₁) denote price index numbers of exports and imports respectively in the current year.

Since the prices of both exports and imports in the base year are taken as 100, the terms of trade in the base year would be equal to one

Px₀/ Pm₀ = 100/100 = 1

Gross Barter Terms of Trade:

This concept of the gross terms of trade was introduced by F.W. Taussig and in his view this is an improvement over the concept of net barter terms of trade as it directly takes into account the volume of trade. Accordingly, the gross barter terms of trade refer to the relation of the volume of imports to the volume of exports. Thus,

T_g = Om/Qx

Where

Tg = gross barter terms of trade, Qm = quantity of imports

Qx = quantity of exports

Income Terms of Trade:

In order to improve upon the net barter terms of trade G.S. Dorrance developed the concept of income terms of trade which is obtained by weighting net barter terms of trade by the volume of exports. Income terms of trade therefore refer to the index of the value of exports divided by the price of imports. Symbolically, income terms of trade can be written as

Ty = Px.Qx/Pm

Were,

T_y = Income terms of trade

P_x = Price of exports

Q_x = Volume of exports

P_m= Price of imports

The Heckscher–Ohlin model (H–O model) is a general equilibrium mathematical model of international trade, developed by Eli Heckscher and Bertil Ohlin at the Stockholm School of Economics. It builds on David Ricardo’s theory of comparative advantage by predicting patterns of commerce and production based on the factor endowments of a trading region. The model essentially says that countries export products that use their abundant and cheap factors of production, and import products that use the countries’ scarce factors.

The Heckscher-Ohlin model is an economic theory that proposes that countries export what they can most efficiently and plentifully produce. Also referred to as the H-O model or 2x2x2 model, it’s used to evaluate trade and, more specifically, the equilibrium of trade between two countries that have varying specialties and natural resources.

The model emphasizes the export of goods requiring factors of production that a country has in abundance. It also emphasizes the import of goods that a nation cannot produce as efficiently. It takes the position that countries should ideally export materials and resources of which they have an excess, while proportionately importing those resources they need.

Features of the model

Relative endowments of the factors of production (land, labor, and capital) determine a country’s comparative advantage. Countries have comparative advantages in those goods for which the required factors of production are relatively abundant locally. This is because the profitability of goods is determined by input costs. Goods that require locally abundant inputs are cheaper to produce than those goods that require locally scarce inputs.

For example, a country where capital and land are abundant but labor is scarce has a comparative advantage in goods that require lots of capital and land, but little labor such as grains. If capital and land are abundant, their prices are low. As they are the main factors in the production of grain, the price of grain is also low and thus attractive for both local consumption and export. Labor-intensive goods, on the other hand, are very expensive to produce since labor is scarce and its price is high. Therefore, the country is better off importing those goods.

Theoretical Development

The Ricardian model of comparative advantage has trade ultimately motivated by differences in labour productivity using different “technologies”. Heckscher and Ohlin did not require production technology to vary between countries, so (in the interests of simplicity) the “H–O model has identical production technology everywhere”. Ricardo considered a single factor of production (labour) and would not have been able to produce comparative advantage without technological differences between countries (all nations would become autarkic at various stages of growth, with no reason to trade with each other). The H–O model removed technology variations but introduced variable capital endowments, recreating endogenously the inter-country variation of labour productivity that Ricardo had imposed exogenously. With international variations in the capital endowment like infrastructure and goods requiring different factor “proportions”, Ricardo’s comparative advantage emerges as a profit-maximizing solution of capitalist’s choices from within the model’s equations. The decision that capital owners are faced with is between investments in differing production technologies; the H–O model assumes capital is privately held.

Evidence Supporting the Heckscher-Ohlin Model

Although the Heckscher-Ohlin model appears reasonable, most economists have had difficulty finding evidence to support it. A variety of other models have been used to explain why industrialized and developed countries traditionally lean toward trading with one another and rely less heavily on trade with developing markets.

The Linder hypothesis outlines and explains this theory. It states that countries with similar incomes require similarly valued products and that this leads them to trade with each other.

Heckscher-Ohlin Theorem:

According to Ricardo and other classical economists, international trade is based on differences in comparative costs. It is important to note that Heckscher and Ohlin agreed with this fundamental proposition and only elaborated this by explaining the factors which cause differences in compara­tive costs of commodities between different regions or countries. Ricardo and others who followed him explained differences in comparative costs as arising from differences in skill and efficiency of labour alone.

This is not a satisfactory explanation of differences in comparative cots. Ohlin pointed out more significant factors, namely, differences in factor endowments of the nations and difference in factor proportions of producing different commodities, which account for differences in com­parative costs and hence from the ultimate basis of inter-regional or international trade.

Thus, Heckscher-Ohlin theory does not contradict and supplant the comparative cost theory but supple­ments it by offering sufficiently satisfactory explanation of what causes differences in comparative costs.

According to Ohlin, the underlying forces behind differences in comparative costs are two­fold:

1. The different regions or countries have different factor endowments.
2. The different goods require different factor-proportions for their production.

It is a well-known fact that various countries (regions) are differently endowed with productive factors required for production of goods. Some countries posses relatively more capital, some rela­tively more labour, and some relatively more land.

The factor which is relatively abundant in a country will tend to have a lower price and the factor which is relatively scarce will tend to have a higher price. Thus, according to Ohlin, factor endowments and factor prices are intimately associ­ated with each other.

Suppose K stands for the availability or supply of capital in a country, L for that of labour and PK for price of capital and PL for the price of labour. Further, take two countries A and B; in country A capital is relatively abundant and labour is relatively scarce. The reverse is the case in country B. Given these factor-endowments, in country A capital will be relatively cheaper.

In symbolic terms:

Since (K/L)A > (K/L)B

Since (PK/PL)A < (PK/PL)B

Thus, the differences in factor endowments cause differences in factor prices and therefore ac­count for differences in comparative costs of producing different commodities. Together with the difference in factor-endowments, differences in factor proportions required for the production of different commodities also constitute an important force underlying differ­ences in comparative costs as between different countries.

Some commodities are such that their production requires relatively more capital than other factors; they are therefore called capital- intensive commodities. Still other commodities require relatively more land than capital and labour and are therefore called land-intensive commodities.

These differences in factor-productions (or what is also called differences in factor-intensities) needed for the production of different commodi­ties account for differences in comparative costs of producing different commodities. The differ­ences in comparative costs of producing different commodities lead to the differences in market prices of different commodities in different countries.

It follows from above that some countries have a comparative advantage in the production of a commodity for which the required factors are found in abundance and comparative disadvantage in the production of a commodity for which the required factors are not available in sufficient quanti­ties.

Thus, a country A which has a relative abundance of capital and relative scarcity of labour will have a comparative advantage in specialising in the production of capital-intensive commodities and in return will import labour-intensive goods. This is because (PK/PL)A < (PK/PL)B.

On the other hand, a labour-abundant country B with a scarcity of capital will have a compara­tive advantage in specialising in the production of labour-intensive commodities and export some quantities of them and in exchange for import capital-intensive commodities. This is because in this country (PL/PK)B < (PL/PK)A.

If factor endowments in the two countries are the same and factor-productions used in the production of different commodities do not differ, there will be no differences in relative factor prices [i.e. (PK/PL)A < (PK/PL)B] which will mean differences in comparative costs of producing commodities in the two countries will be non-existent. In this situation the countries will not gain from entering into trade with each other.

Let us graphically explain the Heckscher-Ohlin theory of international trade. Take two coun­tries U.S.A. and India. Assume that there is a relative abundance of capital and scarcity of labour in U.S.A. and, on the contrary, there is a relative abundance of labour and scarcity of capital in India. (This is the real situation as well).

By WissensDürster – Own work, CC BY-SA 4.0, https://commons.wikimedia.org/w/index.php?curid=41687581

It is said that an internal debt has no direct money burden since the interest payment on debt and the imposition of taxation to pay interest to the lenders is simply a transfer of purchasing power from one to another. This means that in case of internal debt, money is borrowed from individuals and institutions within the country.

Repayment (raised from taxation) constitutes just a transfer of resources from one group of persons to another. In other words, these are transfer payments and do not affect the total resources of the community Truly speaking, govern­ment collects money through taxation imposed on the richer people who are also the buyers of government bonds.

Burden of public debt is a misleading and highly confused concept. The 1930’s and 1940’s witnessed an array of debate over the issue of debt burden. The focus of debate was between those who feared that the creation of debt in course of deficit finance would burden the future and others who believed that such finance would not do so.

Later on, two extreme views emerged in this regard. The burden con­troversy attained its logical end in the pronouncement of A.C. Pigou, A.P. Lerner, Alwin. H. Hansen and Prof. P.E. Taylor.

In this context, Prof. Taylor point out that “the nature and severity of the burden have however frequently been improperly understood largely because of the temptation to think of public debt in terms of private debt and to apply identical standards to both”.

Moreover, while discussing the burden of public debt, we have to bear in mind not only the amount of debt but also the corresponding credit. As A.P. Lerner point out “the great misconception lies in looking at only one side of debt-credit relationship.

Every debt has a corresponding credit and this fact is frequently over looked when considering the burden of public debt. In this context, Taylor point out “the liability of the debtor to the creditor is matched by the asset value of the creditors claim.

This is a rou­tine fact which is frequently over looked when considering the nature of debt”. The views of these economists remained unchanged for quite a long time. The Keynesian approach disagreed with the clas­sical burden thesis.

Burden of External Debt:

During a given period, the direct money burden of external debt is the interest payment as well as the principal repayment (i.e., debt servicing) to external creditors. The direct real burden of such external borrowing is measured by the sacrifice of goods and services which these payments involve to the members of the debtor country.

There is also indirect money burden of external debt. Loan repayment by the debtor country implies more exports of goods and services to the creditor country. Thus, a debtor country experiences a fall in welfare of the community.

1. Traditional Views on the Burden of Public Debt:

The traditional view is that public debt as in the case of private debt imposes a real burden on the community. The classical view main­tains that if the government expenditure is financed through taxation the present generation bears the burden. But if government expendi­ture is financed through public borrowing, the present generation gets relieved from the cost and burden is shifted to the future genera­tion.

The future generation suffers when present generation reduces its saving in-order to meet the debt finance and leave a smaller amount of capital resources for the future. This will reduce the productive capacity of the future generation and accordingly they will stand to lose.

In a sense, war finance through public debt has double effect. For example, in-order to contribute to war finance, the present gen­eration has either to curtail its consumption or saving or both. If savings are reduced the future generation suffers on account of re­duced inherited capital.

On the other-hand, if the present generation does not reduce its consumption, burden of public debt may pass on to the future generation. This view is held by David Hume, Adam Smith and David Ricardo.

According to the classists public debt necessitate a transfer of resources from the private sector to the government in the form of additional taxation. Secondly, the classist held the view that public debt is a more costly method of financing public expenditure than taxation.

This is so because interest payment is an additional cost burden in the case of public debt. Thirdly as stated earlier, public debt tends to transfer the burden of a particular outlay to the future generation.

Moreover, excess borrowing and mounting public debt of the government may undermine the very creditworthiness of the gov­ernment. Hence the traditional economists strongly argued that public debt should be kept to the minimum and should be redeemed as early as possible.

2. Modern Views:

Economists like J.M. Keynes, Harris, Buchanan, Musgrave, and Modigliani are the chief exponents of the modern version of debt burden. The modem theory of public debt is put as “the new ortho­doxy” by Prof. Buchanan.

The worldwide depression of 1930’s and the emergence of Keynesian economics paved the way for the de­velopment of the new theory of public debt. The new theory is dia­metrically opposed to the classical concept of public debt. Modern theory firmly advocates that large volume of public debt is a national asset rather than a liability. This theory recognizes that persistent deficit spending is a tonic to the economic development of nations.

During periods of depression, the technique of deficit budget financed through borrowing can be fruitfully utilized to improve employment situation and generating effective demand and thereby raising the level of economic activity.

Under the shadow of Says Law, propa­gated the misconception that persistent technique of unbalancing the budget coupled with increasing proportion of public debt endangers the very economic stability of the nation.

However, the modern theories strongly believe that public expenditure is not at all wasteful. To them, public expenditure can be made productive and an impor­tant means to increase employment in the economy.

As a corollary to this concept, Prof. A.H. Hansen, the chief advocate of modern theory states that public debt is an essential means of increasing employment and it has become an instrument of modern economic policy of nations.

Prof. James Buchanan in his book “Public principles of public debt”, states that debt burden implies a compulsory sacrifice. He argued that the primary burden of the internally held public debt is always in the future.

Buchanan held the view that burden of debt should be considered in terms of reduction in personal satisfaction. When a public debt is floated, the lenders voluntarily purchase bonds. There is no loss of satisfaction in the process of exchanging more liquid money for less liquid bonds. Here people prefer government bonds as a good form of investment.

3. Direct Money Burden:

Repayment of public debt involves payment of interest and the prin­ciple by the government. Hence the government will have to raise the necessary resources by way of taxation.

The direct money burden of public debt consists of the tax burden imposed on the public and it is equal to the sum of money payments for interest and the principle components. In the case of an internal debt, there will be no direct money burden because all the money payments and receipts can­cel out.

In this context, Dalton observes “thus all transactions con­nected with an internal debt resolve themselves into a series of transfers of wealth within the community. It follows that there can never be any direct money burden or direct money benefit of an internal debt”. However, in the case of external debt money pay­ments by the debtor nations to the creditor constitute a clear direct money burden.

4. Direct Real Burden:

Real burden of public debt refers to the distribution of tax burden and public securities among the people. In a sense, it is the hardship sacrifice and loss of economic welfare shouldered by the taxpayers on account of increased taxation imposed for repayment of public debt.

It is a fact that people hold public debt and they also pay taxes towards the cost of debt service. If the proportion of taxation paid by the rich towards the cost of debt, service is smaller than the propor­tion of public securities held by them, whereas, if the proportion of taxation paid by the poor and middle-income group towards the cost of debt service is larger than the proportion of public securities held by them, there is a direct real burden from public debt.

Whereas suppose government bonds and securities are held by the working classes, while the taxation towards the cost of debt service is paid by the rich only, then public debt will help to reduce the inequalities of income in the community. In such a circumstances there is no direct burden; instead there is a direct real benefit to the community.

5. Indirect Money Burden and Real Burden:

It is argued that heavy taxation to meet debt service charges may reduce taxpayers ability and willingness to work an save. In turn this will check production. Moreover, heavy debt charges may also force the government to curtail and economies some desirable social ex­penditure, which may promote economic development.

However, if it is possible to neutralize the adverse effect of taxation resulting from the problem of debt service by some favourable effect of public ex­penditure, the indirect burden of public debt can be cancelled out. Dalton observes that practically this is not possible. In the case of external debt, indirect money and real burden arise from its bad effect on production because of additional taxation to pay for debt charges.

Burden of Internal Debt:

Internal debt involves no significant burden on the community as a whole. The payment of interest and increased taxation to meet the servicing and principle component of debt involves a transfer of pur­chasing power from one section of the community to another.

In the case of internal debt, the people owe themselves the debt and the question of the burden need not be treated as raising any major issue. Money does not flow out of the domestic market.

However, if the creditors (bond holders) and the taxpayers belong to different income strata’s, there may occur a change in the distribution of in­come among different sections of the community. But Dalton observes that while estimating the burden of public debt, we should consider the purpose for which the loan is raised.

Suppose if the public debt is floated specifically for raising invest­ment funds for a productive activity, the profit generated from it can be used to pay off the debt, where as a debt raised for financing a war may be a dead weight and it will have to be paid out of increased taxation.

So in the first case there is no burden as such. In the second case also it is argued that the burden imposed by taxation upon the taxpayers will be offset by the benefit which the taxpayers receive in the form of interest on public debt.

However, if the rich pays taxes less than proportionately, to the proportion of public securities held by them, then there will be a direct real burden. The reason is that usually public securities are held mainly by the wealthier class.

Progressive taxation doesn’t tend to be sharply progressive to counterbalance the gain obtained by wealthier class from the possession of public debt. In usual prac­tice, the debt servicing burden will fall upon the poor section in the form of heavy taxation on commodities.

As a result there is a net increase in the burden on the community. Sometimes this may ad­versely affect the power and willingness to work and save and even the productive capacity of the economy.

Hence, the repayment pro­cess of public debt should be managed in such a way that, it may not exert any adverse effect on production and distribution. So it maybe concluded that if not planned and utilized scientifically, inter­nal debt can practically impose a burden on the community, even though theoretically it is not correct.

On several aspects external debts differ from internal debt. Still in the case of burden of debt, both share some similar characteristics. For the payment of internal and external debt, imposition of additional taxation is imperative.

In the words of Prof. Dalton “as a general rule, an internal debt is likely to involve an additional and indirect burden on a community, an external debt does the same”.

But in another sense, external debt involves greater burden than internal debt. In the case of internal debt there is no resource trans­fer to outside the country. The repayment of principle and interest charges doesn’t lead to the transfer of resources from the country to another country.

It merely results in the transfer of income from one section of the community to another section. Moreover, the taxpay­ers and receivers of interest constitute the same class of people. Whereas external debt specifically involves resource transfer to for­eign nation.

By way of interest charges and repayment of principle, resources are transferred to the creditors abroad. Therefore, pay­ment of interest on foreign debt reduces the net income of the debtor country. Internal debt carries with it no such evil effect. Hence, we can safely say that external debt involves a greater burden than internal debt.

Measurement of the Burden of Debt:

Usually, burden of debt refers to financial burden of the government.

But as it does not indicate true burden, we consider following ratios to estimate the burden of debt:

• Income-Debt Ratio:

It is estimated as:

size of public debt/national income = D/Y

If Y remains at a very high level, the burden of debt, D, will be insignificant. However, if the ratio becomes high, debt then poses a great burden.

• Debt-Service Ratio:

This ratio is measured as:

Annual interest payments of borrowing/National income = i/Y

Increase in Y means lower debt-service ratio. However, taxes are collected for the repayment of public debt. Thus, this ratio indicates the necessity of imposing higher taxes.

• Debt Service-Tax Revenue Ratio:

It is worked out as:

Annual interest payments/Aggregate tax revenue = i/T

An increase of this ratio indicates the financial weaknesses of the government.

Government’s fiscal policy has big role in stabilizing the economy during business cycles. The two important phases of business cycles are boom and recession. A recession should not be allowed to grow into a deep recession. Similarly, a boom should not explode bigger. We may say that amplifying the business cycle is dangerous (growing boom and deepening recession).

Practically fiscal policy responses using taxation and expenditure can go in two ways in response to the business cycle: Countercyclical and procyclical.

Countercyclical fiscal policy

Procyclical and countercyclical variables are variables that fluctuate in a way that is positively or negatively correlated with business cycle fluctuations in gross domestic product (GDP). The scope of the concept may differ between the context of macroeconomic theory and that of economic policy–making.

The concept is often encountered in the context of a government’s approach to spending and taxation. A ‘procyclical fiscal policy’ can be summarised simply as governments choosing to increase government spending and reduce taxes during an economic expansion, but reduce spending and increase taxes during a recession. A ‘countercyclical’ fiscal policy takes the opposite approach: reducing spending and raising taxes during a boom period, and increasing spending and cutting taxes during a recession.

A counter-cyclical fiscal policy refers to strategy by the government to counter boom or recession through fiscal measures. It works against the ongoing boom or recession trend; thus, trying to stabilize the economy. Understandably, countercyclical fiscal policy works in two different direction during these two phases.

Countercyclical fiscal policy during recession

Recession is a business cycle situation where there is slowing demand and falling growth in the economy. Here, the Government’s responsibility is to generate demand by fine-tuning taxation and expenditure policies. Reducing taxes and increasing expenditure will help to create demand and producing upswing in the economy.

Countercyclical fiscal policy during boom

In the case of boom, economic activities will be on upswing. Amplifying the boom is disastrous as it may create inflation and debt crisis and the government’s responsibility here is to bring down the pace of economic activities. Increasing taxes and reducing public expenditure will make boom mild. Thus, slowing down demand should be the nature of countercyclical fiscal policy during boom.

Procyclical fiscal policy

Procyclical is the opposite of countercyclical. Here, fiscal policy goes in line with the current mood of the business cycle; amplifying them. For example, during the time of boom, government makes high expenditure and doesn’t hike taxes. Thus, boom grows further. Such a policy is dangerous and brings instability in the economy.

Boom: total government spending as a percentage of GDP goes up and tax rates go down, increasing government deficit.

Recession: total government spending as a percentage of GDP goes down and tax rates go up, decreasing government deficit.

So procyclical fiscal policy is undesirable for the economy.

History shows that governments follow often procyclical fiscal policy more during boom. Such a situation increases government debt and creates inflationary pressure especially in developing countries.

Economic policy making

Procyclical

Procyclical has a different meaning in the context of economic policy. In this context, it refers to any aspect of economic policy that could magnify economic or financial fluctuations. Of course, since the effects of particular policies are often uncertain or disputed, a policy will be often procyclical, countercyclical or acyclical according to the view of the one judging it.

Thus, the financial regulations of the Basel II Accord have been criticized for their possible procyclicality. The accord requires banks to increase their capital ratios when they face greater risks. Unfortunately, this may require them to lend less during a recession or a credit crunch, which could aggravate the downturn. A similar criticism has been directed at fair value accounting rules. The effect of the single Eurozone interest rate on the relatively high-inflation countries in the Eurozone periphery is also pro-cyclical, leading to very low or even negative real interest rates during an upturn which magnifies the boom (e.g. ‘Celtic Tiger’ upturn in Ireland) and property and asset price bubbles whose subsequent bust magnifies the downturns.

Countercyclical

Conversely, an economic or financial policy is called countercyclical if it works against the cyclical tendencies in the economy. That is, countercyclical policies are ones that cool down the economy when it is in an upswing, and stimulate the economy when it is in a downturn.

Keynesian economics advocates the use of automatic and discretionary countercyclical policies to lessen the impact of the business cycle. One example of an automatically countercyclical fiscal policy is progressive taxation. By taxing a larger proportion of income when the economy expands, a progressive tax tends to decrease demand when the economy is booming, thus reining in the boom. Other schools of economic thought, such as new classical macroeconomics, hold that countercyclical policies may be counterproductive or destabilizing, and therefore favor a laissez-faire fiscal policy as a better method for maintaining an overall robust economy. When the government adopts a countercyclical fiscal policy in response to a threat of recession the government might increase infrastructure spending.

Business cycle theory

Procyclical

In business cycle theory and finance, any economic quantity that is positively correlated with the overall state of the economy is said to be procyclical. That is, any quantity that tends to increase in expansion and tend to decrease in a recession is classified as procyclical. Gross Domestic Product (GDP) is an example of a procyclical economic indicator. Many stock prices are also procyclical because they tend to increase when the economy is growing quickly.

Countercyclical

Conversely, any economic quantity that is negatively correlated with the overall state of the economy is said to be countercyclical. That is, quantities that tend to increase when the overall economy is slowing down are classified as ‘countercyclical’. Unemployment is an example of a countercyclical variable.[4] Similarly, business failures and stock market prices tend to be countercyclical. In finance, an asset that tends to do well while the economy as a whole is doing poorly is referred to as countercyclical, and could be for example a business or a financial instrument whose value is derived from sales of an inferior good.