International monetary system

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International monetary system

  1. 1. Gains from Trade
  2. 2. Adam Smiths Theory of Absolute Advantage  Country should specialize in the production of commodities which it can produce most efficiently – Lower Cost of Production.  A country tends to specialize in production of commodities in which it has Absolute Advantage Per Quintal Labour Cost (Man- hour) Country Rice Jute India 30 60 Bangladesh 50 20
  3. 3. Adam Smiths Theory of Absolute Advantage Would should country’s be doing?  India     India should specialise in Rice production. As India has to sacrifice 2 Qtl of Rice for 1 Qtl of Jute. It can import jute from Bangladesh 1Qtl of Rice = 1.5 Qtl of Jute (30/20) Bangladesh  Should specialise in Jute  Import Rice from India  As in domestic trade they get 0.4 Qtl of Rice (20/50) for Jute  If they trade they get 0.67 Qtl of Rice (20/30) for 1 Qtl of jute.
  4. 4. Ricardo's Insight  What if one country has absolute advantage in both the commodities?  Is trade possible?  As long as countries have comparative advantage in the production of both the commodities specialisation and trade would always be possible. Per Quintal Labour Cost (Man- hour) Country Rice Jute India 30 60 Bangladesh 50 80
  5. 5. Ricardo's Insight  India It can produce both the goods efficiently. It has comparative advantage in rice production. It can produce Rice at 60% (30/50) cost then Bangladesh. It has comparative disadvantage in jute because cost of jute production is twice the cost of rice production.  Bangladesh It has comparative advantage in jute production Relative cost of jute production ( 80/50 = 1.6 Qtl of rice) is less than India’s(60/30= 2Qtl of rice).
  6. 6. Gains from Foreign Trade Internal Exchange Rate (Quintal) Bangladesh India Rice Jute Rice Jute 1 0.5 1 0.625 50/80 30/60 2 1 1.6 1
  7. 7. Who Gains from Trade? Who Gains India or Bangladesh?     It depends upon the determination of commodity exchange rate between two countries. India’s exchange rate ranges between 500Kg to 625 kg of Jute for 1 Qtl of Rice. Bangladesh it ranges between 1.6 to 2 Qtl of Rice for 1 Qtl of Jute. If Exchange rate in foreign trade are same as internal rates then both the country gain.
  8. 8. Heckscher-Ohlin Theory of Trade  The comparative advantage in the cost of production is due to the difference s in the factor endowment of the nations.  It refers to the overall availability of usable resources in the country. A country tends to specialise in the export of a commodity whose production requires intensive use of its abundant resources and imports a commodity whose production requires intensive use of its scarce resources.
  9. 9. International Monetary System
  10. 10. The Gold Standard  The earliest form of International Monetary system   In use for 4 decades before the onset of World War I The principles    Domestic currency system (coins or paper) – fully repayable in Gold Gold could be freely imported or exported in unlimited quantities between countries The exchange rates were fixed on the basis of their gold parity at fixed par values
  11. 11. The Gold Standard  The mechanism     The flow of Gold from trade deficit countries to trade surplus Gold losing countries experienced reduction in money supply, money income & fall in prices Gold receiving countries experienced increase in money supplies, income & prices These conditions made goods & services flow from trade deficit countries to surplus ones. Thus gold standard system automatically restored equilibrium
  12. 12. The Gold Standard  The breakdown      World War I rudely shattered the economic order Because of hyper Inflation – gold payments were suspended Consequently convertibility of currencies broke down It was expected that freely fluctuating exchange rates would restore competitive price and cost system which would automatically restore stability However, it stimulated speculation in hot currencies      Over valuation of Pound Sterling Undervaluation of French & Belgium Francs Collapse of German Mark Due to war – free trade & flexible exchange rate gave way to restrictions & exchange control And the world went into complete disarray leading to collapse of the gold standard
  13. 13. What Happened Next…  Restoration attempts were not very successful.  And in 1931 with Britain going off gold standard – it finally collapsed  Emergence of currency blocs  Formal & Informal arrangements between members  4 prominent blocs  Sterling area, French Bloc, COMECON (Soviet Bloc), Dollar area  It was a chaotic monetary system  With multiple exchange rates  Exchange rate fluctuations were frequent  Import restrictions & exchange controls were widespread  Competitive devaluation had become order of the day.  All this lead to serious economic erosion of super powers – USA, UK, & France  The order was finally restored with establishment of IMF.
  14. 14. International Monetary Fund  IMF – came into existence in 1945 & started functioning in 1947  Started with 7 members and had 180 members in 2000.  It combined the characteristics of both  Gold standard;   Fluctuating exchange rate   Gold remained the universally accepted medium payment. Dollar & Pound Sterling emerged as reserve currencies supplementing Gold as internationally acceptable assets. Exchange rates were fixed in Gold and also linked to Dollar or Pound  With fixation of exchange rates – convertibility of currencies was restored.
  15. 15. International Monetary Fund IMF also restored multilateral payment system with following conditions.  No country is supposed to impose new exchange controls without IMF’s approval.  To ensure flexibility in exchange rates within prescribed limits – the members were not permitted to vary spot exchange rates more than 1 % beyond upper & lower limits.   To deal with short run payment difficulties a member will be allowed to borrow 25% of the quota in a year – though total borrowing can be 125% of the quota across 5 years. To overcome fundamental disequilibrium – IMF may permit devaluation of currency by 10%. Beyond that only through negotiations
  16. 16. International Monetary Fund With the establishment of IMF:   Within 5 years multilateral payment system was fully restored By 1958 most major currencies had become convertible, restrictions on payment had disappeared and a free payment system was universally established
  17. 17. International Monetary Fund  Purpose of IMF  To promote international monetary cooperation  To facilitate expansion and balanced growth of international trade  To maintain exchange rate stability  To assist members in establishment of multilateral system of payments and elimination of foreign exchange restrictions  To give confidence to members by making fund’s resources available to them to correct balance of payments  To shorten the duration and lessen the degree of disequilibrium in the international balance of payments of members
  18. 18. Collapse of IMF System  In 1960s – there was serious inadequacy of international liquidity  Shortage of gold & foreign exchange reserves to remove in deficit in BOP because world trade was growing faster than world reserves  For instance during 1950-71 world trade grew at 8 % per annum – where as Reserve increased by 2-3% per annum during this period  The smaller stock of gold and fixed exchange rate system created instability.  Led to severe BOP Deficit in USA
  19. 19. Special Drawing Rights  This necessitated the search for a new kind of reserve asset to supplement gold stock & create additional international liquidity SDR
  20. 20. Special Drawing Rights  SDR – is a kind of ‘reserve asset’ – created through amendment of IMF system.  It is nick-named ‘paper gold’ – since it performs the functions of gold in international payment system  It is not     A paper currency Nor a coin Nor a credit note Nor a treasury bill  SDRs are simply entries in SDR-account of participating countries.  Though SDRs figure in the published reserves of a nation.
  21. 21. Special Drawing Rights  SDRs serve as ‘means of payment’ between the participating nations for the purpose of legitimate purchase of foreign exchanges and for making up for the deficit in balance of payment.  In SDR transactions participating nations are not required to transfer their currency or any other asset against SDRs received in allocation.  They are simply credited to the participants’ accounts and are then available for use.  SDRs are defined in terms of a basket of major currencies used in international trade and finance. The amounts of each currency making up one SDR are chosen in accordance with the relative importance of the currency in international trade and finance
  22. 22. Special Drawing Rights  3 ways to transact in SDRs  Receive foreign exchange from a participant designated by the fund  Through mutual agreements between the participants to redeem their own currency held by another nation  For transaction with the Fund’s General Account.  SDR Quota    Quota subscriptions generate most of the IMF's financial resources. Each member country of the IMF is assigned a quota, based broadly on its relative size in the world economy. A member's quota determines its maximum financial commitment to the IMF and its voting power, and has a bearing on its access to IMF financing. Total quotas at end-March 2008 were SDR 217.3 billion (about $357.3 billion).
  23. 23. Special Drawing Rights What are the functions of quotas?  Subscriptions. A member's quota subscription determines the maximum amount of financial resources the member is obliged to provide to the IMF. A member must pay its subscription in full upon joining the Fund: up to 25 percent must be paid in SDRs or widely accepted currencies (such as the U.S. dollar, the euro, the yen, or the pound sterling), while the rest is paid in the member's own currency.  Access to financing. The amount of financing a member can obtain from the IMF (its access limit) is based on its quota, a member can borrow up to 100 percent of its quota annually and 300 percent cumulatively.
  24. 24. Composition of SDR • The largest member of the IMF is the United States, with a quota of SDR 37.1 billion (about $61.0 billion), • The smallest member is Palau, with a quota of SDR 3.1 million (about $5.1 million).
  25. 25. The Present IMF System  The present IMF is on MANAGED FLOATING SYSYTEM  It allows member nations the choice of foreign exchange as long as it does not injure the interest of their trade partners.  Most of the nations pegged their currencies to the US Dollar, SDR and basket of currencies.
  26. 26. Trade Agreements
  27. 27. Need for Trade Agreements  Helps in overcoming trade barriers  Promotes trade amongst member countries  Increases efficiency – through economies of scale (spreading fixed cost over larger regional markets)  Increased economic growth from foreign direct investment  Promotes regional infant industries through protected regional market  Increased security of market access for smaller countries.  Improves members bargaining strength in multilateral trade negotiations.  Strengthens political ties and managing migration flows.
  28. 28. Trade Agreements Trade Agreements Bi-lateral Regional Multi-lateral
  29. 29. Trade Agreements  Bi-Lateral Agreement Trade agreements between two countries.  Regional Trade Agreements (RTAs) : Trade agreements between group of countries – may or may not belong to same geographical region  Multi-lateral Agreements Trade agreements between multiple countries – GATT/WTO
  30. 30. Multilateral Trade  GATT ( General Agreement of Trade and Tariff)  Formed in 1948 to liberalize Trade.  Till 1994 this was the forum for negotiating lower customs duty rates and reducing other trade barriers.  Provided a framework for trade expansion vis-à-vis removing barriers on free movement of goods and services.  ‘Rounds’ the West, negotiated trade deals with themselves in mind.  The developing world were forgotten as backward and without any clout.
  31. 31. GATT v/s WTO GATT WTO It is Adhoc and provisional. Its agreement are permanent. It had contracting parties. It has members. It allowed existing domestic legislation to continue even if it violated the agreement. WTO does not permit it. It was less powerful, dispute system settlement system was slow and less efficient and its ruling could be blocked. WTO is more powerful, mechanism faster and more efficient and difficult to block the rulings.
  32. 32. WTO IMPACT GATT / GATS TRIMS TRIPS Liberalisation of trade in goods and services Liberalisation of international investment Provides monopoly power to owners of intellectual
  33. 33. Multilateral Trade  The WTO (World Trade Organisation) is an international organization dealing with the rules of trade between countries.  The WTO can be said to be made up of different entities:  Laws governing international commerce and are contracts by which governments agree to trade policies that would be beneficial to all the WTO member nations.  Countries can negotiate these agreements, settle disputes arising from the agreements and help other countries join the negotiations .  WTO is GATT plus – GATS (General agreement on trade in services) and TRIPS (Trade related intellectual property rights).  Helping countries, especially developing countries, develop and review national trade policies.
  34. 34. Regional Trade Agreements
  35. 35. RTA focus – not only true for India but it is a global reality 300 2007
  36. 36. Types of RTA’s
  37. 37.  Preferential Trade Agreement:  A grouping of countries where partial preference to trading partners are given. Central American Common Market (CACM)  Free Trade Area:  A grouping of countries to bring free trade between them.  North American Free Trade Area (NAFTA)  ASEAN Free Trade Area (AFTA)  EFTA ( European Free Trade Association)  LAFTA ( Latin america Free trade association)  Custom Union:  Eliminates all restrictions on Trade members but also adopts a uniform commercial policy against the non-member.  European Economic Community (EEC)
  38. 38.  Common Market:  It allows free movement of labour and capital in addition to having free movements of goods and having common commercial policy for non-members.  ECM ( European Common Market)  CACM ( Central American Common Market)  Economic Union:  Members countries have same economic policies, including monetary and fiscal policy.  EU ( European Union)
  39. 39. “What should be India’s focus – bilateral/ regional or multilateral trade agreement?”
  40. 40. Multilateral Trade  Overwhelming dominance of developed countries in the WTO.  The developing countries have not gained any meaningful increase in market access in the key areas where they have comparative advantage (textiles and agriculture).  Liberalization of services or trade has occurred only in sectors which are of primary interest to developed countries like IT, ITES, automobile and some manufactured goods.  Declining industrial tariff and removal of all quantitative restrictions has the potential to harm the industrial sector of developing countries.  Free trade is more suitable to the advanced countries which have already established their industrial base.
  41. 41. Bilateral/ Regional Trade  Help the developing countries to expand market access without compromising on national policies and interests  Lead to lower dependence on developed country markets and help in resisting the pressures of economic superpowers  Helps to forge and foster stronger alliances at the multilateral trade negotiations.  Allows infant industry protection
  42. 42. Thus, India is :  Focussing on BLT/RTAs first. So that it can balance differences and build capabilities at par with developed countries and then move towards a multilateral trade regime.  Some of the recent alignments  Free trade area (FTA) agreements with Sri Lanka and Thailand  Advance stages of free trade area agreement with Singapore  Signed a framework agreement for a free trade area with the members of the Association of South East Asian Nations (ASEAN)  An agreement to create a South Asian Free Trade Area (SAFTA).  Approached distant trading partners such as South Africa and Brazil

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