Tax revenue

Tax base

Progressive

Proportionate

Regressive

International trade

Demotic trade is a trade that takes place within the demotic boundaries

International trade is the trade between two countries trade that takes place between the residence of the country and rest of the world.

Benefit of international tradeSome countries can offer some goods at lower price due to various reasons such as resource.

International trade will consumers will get certain goods at a price (lower) and producers will get semi-finished good at a lower price

Greater verity of choice…

Country may not have enough natural resources and may need to import it.

Since they will be supplying to world market more products will be produced therefore it will increase its EOS

Increased competition result in efficiency

Permits specialization they may specialize in those that will give them comparative advantage.

Decrease domestic monopoly power

International trade interdependent less conflict

International trade

Concepts of international tradeVolume of trade is physical quantity

Value of trade is money value

Pattern of trade is trade composition is import & exports items, trading partners.

Theory of absolute advantageAccording to smith benefits of the trade are based on the theory absolute advantage

Some countries are more efficient in producing some goods. Each country should specialize in production of those goods in which it has absolute advantage. This is when it can produce more of it with same resources or can produce one unit of it using fewer resources.

Using the same amount of resources:

Textiles MachinesBangladesh 6 1S. Korea 4 3World production 10 4If there is trade then world production is

12 6

When there is no trade no country specializes and produces both the goods

If the trade occurs then each country will produce the advantageous good therefore the world production increases.

Textile

Machines

PPF Bangladesh

PPF Korea

PPF for both countries after trade

International tradePPF of the countries

Bangladesh will specialize in production of textile & will exchange textile for machines with Korea.

If Bangladesh gets more than 1 machine by sacrificing 6 textiles they are benefiting. If Korea gets more than 4/3 textiles by giving 1 machine they are benefiting. In world market 1 machine = 2 textiles. Bangladesh can give 6 textile and get 3 machines benefit Korea can give 3 machines and get 6 textile benefit

Theory of comparative advantage‘1817’- ‘David Ricardo’

Textile MachinesIndia 20 20Bangladesh 18 9According to him, a country should have comparative advantage (a country will have it, in production of a good if it can produce it at a relatively lower cost/ lower opportunity cost (OP)/ that is by sacrificing fewer of lesser units of other goods) to trade.

In India OP of production of textile = 1 machine In India OP of production of machine = 1 textile In Bangladesh OP of production of textile = 0.5 machine In Bangladesh OP of production of machine = 2 textile Because India has comparative advantage in machines they should product that while since

Bangladesh has comparative advantage in textile, they should product that.

Bangladesh

India

Machine

Textile

International trade For trade to take place both the country should benefit. World rate 1 textile = 0.75 machines By giving up 20 machines India will get 26.66 textile By giving up 18 texting Bangladesh will get 13.5 machines Therefore both are in profit.

Without trade India 20 textile, 20 machines with trade 26.66 textiles, 20 machines

Without trade Bangladesh 18 textile and 9 machines with trade 18 textile, 13.3 machines

Criticism This model is based on certain assumption like perfect mobility of factors within a country Constant opportunity cost No transportation cost Existence of perfect competitions These assumptions are unrealistic

Cost of production and there by opportunity cost may not be constant as increased scale of compaction the companies will face EOS

Comparative advantage is a dynamic concept and may change

DS

Price of cotton

Quantity of cotton

EP*

Q*

Pw ws

Q1 Q2

International trade Existence trade barriers like tariff and subsidies does not allow world trade to reflect true

comparative advantages

Factor determining comparative advantages 1. The quality and quantity of resources / factors of production (size and efficiency of labor force,

capital stock, investment, rate etc.)2. Exchange rate, if exchange rate of a country falls, then domestic goods of that country becomes

cheaper in world market. Therefore, the country gains comparative advantage.3. Rate of inflation, if a country experiences a relatively high rate of inflation, as compared to its

trading partners, its goods will become relatively expensive and become less competitive4. Country can generate artificial competitive advantage in certain areas by subsidies

Note CA is not a static concept and may change over time. Govt. may promote policies which will create CA in industries. E.g. Asian tigers had CA in production of low scaled labor intensive good, however through investment in edu. and training, R&D and infrastructure. The govt. of this country could produce CA in high skilled capital intensive product.

Free trade and protectionism When international trade between 2 countries is free from any kind of trade barrier.

Trade will only take place when world price is less than domestic price.

At Pw price can import any amount of cotton and will face perfectly elastic world supply curve.

Output

Price

Imposing tariff

Import after tariff

Revenue made by govt.

Prod. By Inefficient domestic producer

Loss in consumer welfare

International tradeIf there is free trade, the price of cotton in Bangladesh will fall to Pw. At Pw price domestic supply is Q1 and demand is Q2.

After trade

Gainers: consumers (lower price and more quantity)

Losers: domestic producers (lower price, less production, increased unemp.)

Protestantism: policies that restricts free trade

Tariff: tax on import

Increase price will reduce quantity demanded.

Therefore the consumers consume less and pay more.

Therefore consumers are loser

And since they produce more therefore the domestic producers are gainers

More employment.

Import decrease

No trade Free trade

With quotaQuota amt.

Shift after quota

International tradeGovt. earn revenue therefore gainers

QuotaA physical limit on the volume on the imports.

Once govt. imposes the quota (black) there is a shortage in the market (Black RRed) as domestic supply is (under Red before blue) + the import (Blue Box). As there is a shortage the price start rising and therefore the domestic producers find it profitable to produce. And hence the supply curve shifts. (domestic supply). The market reaches an equ. Where the (purple) line representation the present.

After quota the price increases (purple) consumption decreases (purple).

Domestic production increases (under RED leaving blue box till purple) employment generated., (Blue to purple) produced by inefficient producers loss in world efficacy (green).

(light blue) loss in consumer welfare

Import decrease therefore foreign producers suffer

No trade Free trade

International tradeSubsidy

While no trade (Blue) lines were operating

Free trade the mixture of (red & blue lines) started to operate.

After the subsidy the supply curve shifts right. Demotic production increases (Red to Black). Imports decrease from (red purple) to (black purple). (blue box) = money spend by govt.

No trade Free trade

International tradeEmbargoIs a complete band in trade.

No trade diagram

(Blue trig.) loss in efficiency

(orange trig.) loss in welfare

Gainers: domestic prod

Losers: consumer, int prod

Other trade barriers 1. Voluntary export restraints (VERs): these are agreements between exporting and importing

countries in which the exporting country agrees to limit the quantity of export of certain good below a certain level. It is to avoid legal trade restriction by the importing country e.g. china export on south Africa

2. Administrative barriers: when goods are being imported there are certain formalities that have to be undertaken. These are also known as RED TAPISM. If these processes are lengthy and complicated then they can act as an restriction to imports.

3. Health, Safety and Environmental slandered: there are various restrictions placed upon the type of goods that can be sold in the domestic market or on the methods used in the manufacture of those goods. These regulations will also apply to the imported good and hence act as barriers

4. Nationalistic campaign: the govt. may carry out nationalistic campaigns. They may carry out marketing campaigns to encourage people not to buy imported goods

International tradeArguments in favors of protectionism

1. At any point of time there will be some industries that are in decline (sunset industries) because they cannot compete with abroad imports. If these indu. Are large they will create large scale srt. Unemp. Therefore to protect jobs. The govt. may adopt these policies. That by providing protection the indus. Will not survive and it more likely that it will continue declining. It will only prolong the process although there will be short term social cost however it would be more beneficial to allow the resources to flow to areas which are expanding.

2. Protecting the economy form low cost labor. It is often argued that the main reason for the decline of domestic industries is the low cost of labor in exporting countries, and the economy should be protected from export from country where labor cost are low. E.g. there has been demand in US to protect domestic clothing indus. against imports from Asia where wages are low. While imports may generate certain benefits for an economy there will be costs in terms of job loss, greater uncertain, and job insecurity in certain indus. Workers in few country fear that they may lose their job against workers in china and India and therefore demand protectionism.Comparative advantage is lost, consumers will pay high and consume less, country will not gain from the benefit of trade.

3. Anti-bumping measures. Dumping is defined as a situation where goods are exported and sold at a price below cost of production. When this is done it will ruin the domestic producers and if proved the govt. can impose restriction on the import of those product. There is a global trade rule on legitimate pricing. E.g. of dumping US has imposed 99% tariff on tubular pipes on china for dumping It is extremely difficult to prove dumping.

4. To improve trade deficit. Protectionism makes imports more expensive and hence spending on imports decrease, which will reduce trade deficit If protectionists policies are impose, it will invite retaliation from trading; exports may fall resulting in the trade deficit remaining the same. Such policies do not address the root cause of the problem. The deficit may be due to inefficiently in domestic indus. Which makes domestic product uncompetitive (lower quality higher price). Also the prices may be high due to high domestic inflation. The goods maybe less reliable, of poor design, and etc.

5. Protecting infant indus. Or sunrise indus. Many govt. argue that an indus. That is just developing may not enjoy advantages of EOS that larger indus. In other country enjoy. Therefore the domestic indus. May not be competitive against abroad imports until it grows in size and start enjoy EOS.It is very difficult to identify a sunrise indus., most countries have highly developed capital market which allow access to large amount of finical capital. There is no basis to identify that industry of the developing country will start in small scale.

6. Revenue: protectionism in form of tariff will provide govt. Of the less develop country with revenue to finance development projects.

International tradeArguments against protectionism It is same as arguments in favors of free trade

1. Lower price. So consumers will benefit, will consume more, 2. Greater variety of choice for consumers. 3. Greater competition so increased efficiency 4. Allow specialization – world production and efficiency will rise 5. Domestic indus. Can enjoy EOS6. Avoid retaliation

Economic Integration Globalization : refers to increasing economic interdependence of national economics across the world through a rapid increase in cross border movement of goods, service, technology and capital. It is the process of increasing economic integration between countries, leading to the emergence of global market place or a single world market

Process of globalization has been helped by:

1. The growth in MNCs and FDI2. Advancement in IT3. Decrease in transportation cost 4. Trade liberalization 5. WTO aiming for free trade

Economic integration: describes the process where by countries codinate and link their economic policies. As the degory of economic intergration policies increase trade barriers decerase and the fiscle and monetory polices become more hrominised

Regional approach To trade libratization refers to aggerment between 2 country

Regionally based group of countries have formed free trade areas by integrating economically.

There are 5 main types of trading blocks (2 or more country with free trade)

No internal trade barriers

Common external tariff

Factor and asset mobility

Common currency

Common economic policy

Free trade area √Customs union √ √Single market √ √ √Monetary union

√ √ √ √

Economic union

√ √ √ √ √

International tradeFree trade area is a designated group of countries that have agreed to eliminate all kind of trade barriers on most (if not all) good and services traded between them.

A customs union is a free trade area with a common external tariff. The participant countries set up common external trade policies. Purposes for establishing a customs union normally is to increase efficiency and establishing closer political and cultural ties between the member countries. E.g. central American common market, southern African customs union.

Common market is a customs union with common policies on product regulation, and freedom of movement of the factor of production (labor and capital) and of enterprise. E.g. central American common market, west African and monetary union.

Trade creation Increased trade which is likely to follow the creation of a free trade area may not always be total beneficial. A distinction has to be made between trade creation which is beneficial and trade diversion which is not.

If a member country was formally protecting, then the country’s consumer were paying more for less output. Joining a free trade area will make goods available at lower price and in more quantity.

Entry of a country into trade block will help production of goods and services being transported to high cost production to low cost production.

Trade diversion A country may already benefit from low cost world market before entry to the group, it is possible that, as member of the group with common external barrier, they have to buy at a higher price from a member country. E.g. UK, Thailand

Evaluation of trading blocks It depends on the degree of integration

Advantages 1. Members of trading block will enjoy the benefits of free trade.

a. Greater market size for domestic producers b. Greater compaction therefore increased efficiency c. More choice and lower price - consumers

2. Forging investment from outside the trading block will be attracted as the market size increases.3. It will foster greater economic stability and cooperation 4. Will have a greater bargaining power in WTO5. Trade negocatian will be easy in a world which have few large trading blocks than 149 sovereign

states.

International tradeDisadvantages

1. Trade diversion can take place.2. This favor increased trade among the members but enact discrimetive policies against non-

members – therefore it undermines int. trade rules and limits the gains which may have been achieved from a liberalized world trade.

3. The role of WTO is undermined. Multi lateral agreements which are superay to any rigonal trading aggrement will be diffecult to chive. There is a risk that the world may end up split into major blocks, each a potaintial fortress to the other.

WTO

Exchange RatesThe value of one currency (USD (1)) expressed in terms of (NRI (75.5)). Generally currency are exchanged in Int. forren exchange market. FOREX Market. It is an example of perfect competition.

It can be expressed:

1. In terms of other currency.2. In terms of a collection of selected currencies – Exchange rate index – kind of CPI

The exchange rate system The way in which a country manages its exchange rate is call the exchange rate system /regime.

There are 3 of these:

1. Fixed exchange rate system/ regime: in this system the value of the domestic currency is fixed or pegged with the value of other currency or average value of a selection of currency or to the value of a commodity of gold.Therefor the value of the currency it is pegged changes, so does the exchange rate. Normally, this is controlled by govt. or central bank. If the domestic currency increased under the fixed exchange rate system, it is called revaluation. If it decreased then it is called devaluation.

Price of USD in NRI

Amount of USD

International trade

Floating exchange rate system In this system the value of the currency is determined by the demand for and the supply of the currency. There is no govt. or central bank interference.

Note1: when Indians buy USD, they create demand. They are selling INR, supplying INR.

Note2: if the value of the currency increases due to the increase in demand or reduced supply, we say that it is APPRECIATION of the currency.

Note2: if the value of the currency decreases due to the decrease in demand or increase supply, we say that it is DEPRECIATION of the currency.

Note4: 1 USD = Rs 45, and it becomes 1 USD = Rs 42, if say USD has depreciated & INR has appreciated.

Why should people demand foreign currencySuppose USD by Indians.

1. To import US goods and services … if Indians travel to US.2. To invest in US.

a. As FDIb. Or Portfolio Investment (bods, security, stock market.)

3. To hold accounts in US banks.4. Speculative purposes (earning by exchange)

International trade

Factors effecting the demand for a currency 1. Change in income: if a country is experiencing high econ. Growth increase in IN increase in

income of people increase in demand for imported goods increase in demand for foreign currency. [occurs between trading partners]

2. Change in relative prices: if a country experiences a relatively high rate of inflation, the price of its goods will rise and the goods will become less competitive in the world market. This will reduce the demand for its currency in the FOREX market. On the other hand foreign good (imports) will now become relatively cheaper and import spending will raise increasing supply of the domestic currency in the FOREX market.

3. Change in investments prospects: investment flows is also called capital flows. econ. Growth future profit expectations are high attract investment increase FDI portfolio investments rising. (govt. might make policies to attract)

4. Speculations: people may buy foreign exchange not to buy imported good or invest. They may buy it expecting the value to go up in future. This kind of investment is called speculative investment as demand for the currency is purely speculative. Therefore if the value of a currency is expected to rise in future, the demand for it will rise and vice versa.

5. Change in relative interest rates: if an interest rate in a country increase, the domestic bonds as well as saving deposits in the domestic currency will become more attractive to foreign investor as they earn more demand for domestic currency rise and vice versa.

6. Govt. foreign exchange reserves: all govt. hold foreign currency reserves to meet with unforeseen problems. If the govt. wants to increase the reserve of foreign exchange it will buy in the FOREX market and the demand for the currency will increase and vice versa.

International trade

Appreciation and Depreciation

Exchange rate changes with change in demand for currency

Demand increase appreciation

Demand decrease depreciation

If supply increase depreciation vice versa

If demand for USD by Indians increase supply of INR increase.

45 Rs Central/accepted exchange rate

45.9 Rs

45.1 Rs

Ceiling

Floor

a b c

International trade

Managed Exchange Rate System In the free floating exchange rate system there may be extremes fluxions which results in high instability and uncertainty. Therefore it will adversely affect business. In such conditions the govt. and central banks may have to intervene. At present most countries follow managed exchange rate system.

1945-1972 exchange rates were managed to bring stability to world trade.

1. Bretten Woods System.2. IMF System.3. Adjustable peg system.

An acceptable or central exchange was chosen, the govt. tends to maintain this rate with some flexibility built in by allowing the rate to fluctuate within an exchange rate band. The band is expressed in % points on the peg. The top band is the ceiling and the lower is the floor.

Assumption is:

Accepted 45Rs = 1USD

And 2% fluctuation is allowed

Exchange goes beyond the band

Excess demand = bc

International tradeGovt. response:

1. Increase the supply of USD by selling USD from the Foreign exchange reserves.2. If govt. does not have sufficient resources they increase the interest rate (CMP)

Attract US investments in Indian Bonds & deposits supply of USD increase.

Side effects:1. Affect econ growth adversely2. Increase unemployment

Deflates NI imports are function of NI imports fall; exports remain same improve trade balance

3. If 1 & 2 fails to reduce the exchange rate govt. has to reduce imports by adopting protectionist polices

a. Results in retaliation of other country and against WTO policies.

45 Rs Central/accepted exchange rate

45.9 Rs

45.1 Rs

Ceiling

Floor

a b c

International trade

Demand fell therefore exchange rate fell below the floor of USD.

1. Govt. of India may buy USD & increase its reserves (& buy ab amount)2. Indian govt. may reduce the interest rate (EMP) increase NI, decrease unemployment

inflation inflating NI increase imports.

Or

US govt. may increase interest rates (CMP)

3. Indian govt. should adopted free trade polices & US govt. adopt protectionist polices.

Conclusion of both cases.

If exchange rate goes beyond the band in a MES, then the govt. will intervene by:

1. Buying / selling the currency2. Increase/ decrease interest rate – deflating/ inflating the econ.3. Protectionist / free trade

If non work then it means the exchange rate is fundamentally overvalued or undervalued.

If undervalued in this case you change the band (revaluation) (band moves up).

If overvalued in this case you change the band (devaluation) (band moves down)

USD (RMB)

Quantity of USD

International tradeThat’s why it’s called adjustable peg.

Dirty Float Free floating exchange rate system with some govt. intervention. There is no pee announced exchange rate band and the govt. or central bank only intervenes if there is excessive fluxions in short runs by speculations

Advantages and disadvantages of fixed exchange rate system

How the exchange rate is maintained at a fixed level by govt.

If they want the rate to be stable.

1. If demand increases; there is increase in demand = (black blue)a. Sell USD from reserves b. Increase interest rates

2. If vice versa ; the decrease in demand = (red black)a. Buy USD b. Decrease interest rate.

Advantages 1. In fixed fix exchange rate system exchange rates do not change and therefore reduce

uncertainty. Firms engaged in int. trade can predict with more certainty the income. 2. EDP which leads to inflation cannot be employed by govt. as inflation is not compatible with

fixed exchange rate. This leads to greater discipline in making policies. 3. Investors avoid exchange rate risk which could lower their returns from any investments. Thus

more cross border investment will happen.

International trade4. Reduces speculations (theoretically)

Disadvantages 1. The govt. is compelled to keep the exchange rate fixed. And this is mainly done through

manipulation of interest rates. If the exchange rate is in danger of falling the govt. has to increase interest rate which will deflate the economy and increase unemployment. While if the govt. reduces the interest rate there will be inflation. Therefore, to achieve one macro objective (EXTEQL) the govt. has to sacrifice other objectives.

2. The govt. has to maintain a large stock of foreign exchange reserve and gold. In order to defend its currency by buying and selling foreign currency.

3. Determining of exchange rate is very difficult, if the currency is undervalued it will result in international disagreement and if it is overvalued it will adversely affect exports of the country.

4. In this system the govt. can reduce trade deficit by deflating the economy. Lower growth and increase unemployment. The other way of reducing trade deficit is adopting protectionist policies which will cause retaliations.

Advantages and disadvantages of floating exchange rate system

Advantages 1. Automatic adjustment: trade deficit import exp. > export earning demand for imports

have increased increase in demand for foreign currency appreciation of foreign currency imports become expensive export increase trade deficit decrease.

2. Policies makers are free to adopt any demand side policies without bothering about its effect on the exchange rate.

3. There is no need for the central bank to maintain large stock of foreign exchange reserves and gold as the govt. does not need to buy and sell foreign exchange to maintain the rate at a certain rate.

Disadvantages 1. Floating exchange rate system tends to create uncertainty in the int. market. Business trying to

plan for the future finds it difficult to make accurate predictions relating to cost and revenues. This reduces the volume of int. trade.

2. Volatile exchange rate reduces the level of int. investments as it is difficult to assess the returns and the risk involved.

3. In reality exchange rate are not only affected by changes in demand and supply but also by events like 9/11, speculations and govt. interventions because of all this the automatic adjustments may not happen.

4. Govt. may lack policy discipline that a fix exchange rate system imposes. And country may become more prone to inflation.