INTERNATIONAL ECONOMICS
Unit – 1
International Trade - Internal & International trade – Economic
growth and International trade – Features of International Transactions –
International Trade Theories Comparative cost theory – Opportunity cost
theory – H.O theory - International Trade Equilibrium
International trade
International trade is the exchange of capital, goods, and services across international
borders or territories. In most countries, such trade represents a significant share of gross
domestic product (GDP). While international trade has been present throughout much of history
(see Silk Road, Amber Road), it’s economic, social, and political importance has been on the rise
in recent centuries. Industrialization, advanced transportation, globalization, multinational
corporations, and outsourcing are all having a major impact on the international trade system.
Increasing international trade is crucial to the continuance of globalization. Without international
trade, nations would be limited to the goods and services produced within their own borders.
International trade is, in principle, not different from domestic trade as the motivation and the
behavior of parties involved in a trade do not change fundamentally regardless of whether trade
is across a border or not. The main difference is that international trade is typically more costly
than domestic trade. The reason is that a border typically imposes additional costs such as tariffs,
time costs due to border delays and costs associated with country differences such as language,
the legal system or culture.
Another difference between domestic and international trade is that factors of production such as
capital and labor are typically more mobile within a country than across countries. Thus
international trade is mostly restricted to trade in goods and services, and only to a lesser extent
to trade in capital, labor or other factors of production. Trade in goods and services can serve as a
substitute for trade in factors of production.
Instead of importing a factor of production, a country can import goods that make intensive use
of that factor of production and thus embody it. An example is the import of labor-intensive
goods by the United States from China. Instead of importing Chinese labor, the United States
imports goods that were produced with Chinese labor. One report in 2010 suggested that
international trade was increased when a country hosted a network of immigrants, but the trade
effect was weakened when the immigrants became assimilated into their new country.
International trade is also a branch of economics, which, together with international finance,
forms the larger branch of international economics.
Differences between Internal and International Trade
There are certain special features, which differentiate internal trade from international trade.
They are explained as following manner:

Demand and Supply: Demand and supply cannot work out their full effects where
foreign trade is concerned. Where as such factors can work out their full efforts in the
case of internal trade.
Artificial Barriers to Trade: The natural difficulties may be increased by artificial
barriers to trade, either through prohibitive laws as in war time of through customs duties
or protective tariffs in the context of international trade.
Differences in Economic Environment from country to country: Different countries
have different facilities in carrying out their productive activities. Differences in system
of national and local taxation, regulations for health, sanitation, factory organisation,
education and insurance, policy regarding the transport and public utilities, laws relating
to industrial combinations and trade, etc., do exist as between countries. These
differences bring about a difference in the costs of production between them.
Currency differences are still more important because of the fact that exchange is thereby
hampered. For instance, if an Indian manufacturer wishes to sell goods in the U.S.A or
English, he must know the value of the U.S.A or England currency units in terms of
Indian money. Apart form this, each country is under the control of a separate central
bank, each following a separate monetary policy which may greatly affect the foreign
trade of the country.
The geographical and climatic conditions may give rise to territorial division of labour
and localization of industries. Some countries may have natural resources is abundance
such as iron ore, coal, etc., whereas in some other countries climatic conditions give
advantages to them.
Long-distance: International trade is predominantly long-distance. This may affect the
transport costs and the mobility of the different factors of production.
Preference: Preference for home and the prejudice against foreigners remain as one of
the major factors that would explain as to why the rates of earning of the different of
equal efficiency would not be equalized between different countries.
International Trade and Economic Growth
The issues of international trade and economic growth have gained substantial importance with
the introduction of trade liberalization policies in the developing nations across the world.
International trade and its impact on economic growth crucially depend on globalization. As far
as the impact of international trade on economic growth is concerned, the economists and policy
makers of the developed and developing economies are divided into two separate groups.
One group of economists is of the view that international trade has brought about unfavorable
changes in the economic and financial scenarios of the developing countries. According to them,
the gains from trade have gone mostly to the developed nations of the world. Liberalization of
trade policies, reduction of tariffs and globalization have adversely affected the industrial setups
of the less developed and developing economies. As an aftermath of liberalization, majority of
the infant industries in these nations have closed their operations. Many other industries that used

to operate under government protection found it very difficult to compete with their global
counterparts.
The other group of economists, which speaks in favor of globalization and international trade,
come with a brighter view of the international trade and its impact on economic growth of the
developing nations. According to them developing countries, which have followed trade
liberalization policies, have experienced all the favorable effects of globalization and
international trade. China and India are regarded as the trend-setters in this case.
There is no denying that international trade is beneficial for the countries involved in trade, if
practiced properly. International trade opens up the opportunities of global market to the
entrepreneurs of the developing nations. International trade also makes the latest technology
readily available to the businesses operating in these countries. It results in increased competition
both in the domestic and global fronts. To compete with their global counterparts, the domestic
entrepreneurs try to be more efficient and this in turn ensures efficient utilization of available
resources. Open trade policies also bring in a host of related opportunities for the countries that
are involved in international trade.
However, even if we take the positive impacts of international trade, it is important to consider
that international trade alone cannot bring about economic growth and prosperity in any country.
There are many other factors like flexible trade policies, favorable macroeconomic scenario and
political stability that need to be there to complement the gains from trade.
There are examples of countries, which have failed to reap the benefits of international trade due
to lack of appropriate policy measures. The economic stagnation in the Ivory Coast during the
periods of 1980s and 1990s was mainly due to absence of commensurate macroeconomic
stability that in turn prevented the positive effects of international trade to trickle down the
different layers of society. However, instances like this cannot stand in the way of international
trade activities that are practiced across the different nations of the world.
In conclusion it can be said that, international trade leads to economic growth provided the
policy measures and economic infrastructure are accommodative enough to cope with the
changes in social and financial scenario that result from it.
International Trade and Economic growth
Advantages of international trade in economic growth
1. International trade injects global competitiveness and hence the domestic business units
tend to become very efficient being exposed international competition. Due to the
integration with the world economy the entrepreneurs can have easy access to the
technological innovations. They can utilize the latest technologies to enhance their
productivity.
2. The developing countries have higher trade protectionism measures as compared to the
developed countries. The countries that have adopted such measures are seen to reap the
benefits of an open trade regime.

3. The products that are labour intensive like clothing, footwear, textiles etc are exported by
the developing countries to both developed and underdeveloped countries. Such exports
earn heavy tax revenue in countries like Mexico, India, China and many more.
4. International Trade has also brought in a reduction in the poverty level. India was a
closed economy in the 1960s and 70s. There was not even 1% decline in the poverty
level. The entire scenario changed with globalisation and international trade. According
to Prof. Jagadish Bhagwati the reduction in the poverty level is due to a pull up rather
than a trickle down effect. The economic growth brought about by international trade can
generate financial resources. Such resources can be used to set up anti poverty programs .
Better education and health facilities can also be provided to the poor.
5. The exclusion of all types of trade barriers in the agricultural products of the developed
countries will lead to a decline and rise in production and world prices respectively. The
developing countries profit by selling or exporting these products at escalated world
prices.
6. Optimum use of Resources: Foreign trades helps in the optimum use of natural
resources and avoid wastages of resources.
7. Stable Price: It ensures the presence of stable price by avoiding wide fluctuations in
prices. It tries to equalise the world price.
8. Availability of all types of goods: It enables a country to import those goods which it
cannot produce.
9. Increased Standard of living: It ensures more production to meet the demand of the
people of different countries. By increased production, it becomes possible to increase
income and the standard of living of its people. It also increase the standard of living by
increasing more employment opportunities.
10. Large Scale production: It ensures large production because the production is carried on
to meet the demand of its people as well as world market. Large scale production also
ensures a great deal of internal economies which reduces the cost of production
11. Increase sales and profits
12. Gain your global market share

13. Reduce dependence on existing markets
14. Exploit international trade technology
15. Extend sales potential of existing products
Disadvantage of international trade:
1. It is a long distance trade and as such it becomes difficult to maintain close relationship
between the buyer and the seller.
2. Each country has its own language. As foreign trade involves trade between two or more
countries, there is diversity of languages. This difference in language creates problem in
foreign trade.
3. Foreign trade involves preparation of a number of documents which also creates
difficulties in the way of foreign trade.
4. Some restrictions are imposed on export and import of commodities. These restrictions
stands on the progress of foreign trade.
5. Foreign trade involves a great deal of risks because trade takes place over a long
distance. Though the risks are covered through insurance, it involves extra cost of
production becuase insurance cost is added to cost.
6. The gains from trade have gone mostly to the developed nations of the world.
Liberalization of trade policies, reduction of tariffs and globalization have adversely
affected the industrial setups of the less developed and developing economies. As an
aftermath of liberalization, majority of the infant industries in these nations have closed
their operations. Many other industries that used to operate under government protection
found it very difficult to compete with their global counterparts.
7. Hire staff to launch international trading
8. Exhaustion of Natural Resources - It means exhaust all its natural resource in
due courseof time.It encourages an underdeveloped country to export its all raw material
very early.
9. Dependence - Import of cheap quality product increases dependence of foreign
countries to the extent which lead that country no productive (i mean their production
within the country stops altogether.
10. Loss to Agricultural Countries - In INTERNATIONAL TRADE predominantly
agricultural countries are loser to the maximum extent.This is because Demand for
agricultural product is less elastic , there is hardly any increase in their demand despite
fall in the price.
Features of International Transactions

There are several reasons - practical as well as pedagogic - for evolving a separate theory
of international trade and consequent development of a distinctive branch of economics called
"International Economics" dealing with issues and problems of the international economy.
International trade follows different laws of behaviour from those of domestic trade. Therefore, a
separate theory is inevitable. These reasons, in a way, tend to point out the distinguishing
attributes of international transactions. Following Kindleberger, we may enlist the important
features of international trade as under?
Immobility of Factors :
The degree of immobility of factors like labour and capital is generally greater between countries
than within a country. Immigration laws, citizenship requirement, etc., often restrict the
international mobility of labour.
International capital flows are prohibited or severely limited by different governments.
Consequently, the economic significance of such mobility of factors tends to equality within but
not between countries. For instance, wages may be equal in Mumbai and Pune but not in
Mumbai and London.
According to Harrod, it thus, follows that domestic trade consists largely of exchange of goods
between producers who enjoy similar standards of life, whereas, international trade consists of
exchange of goods between producers enjoying widely differing standards. Evidently, the
principles which determine the course and nature of the internal and international trade are bound
to be different in some respects at least.
In this context, it may be pointed out that, the price of a commodity in the country where it is
produced tends to equal its cost of production. The reason is that, if in an industry the price is
higher than its cost, resources will flow into it from other industries, output will increase and the
price will fall until it is equal to the cost of production. Conversely, resources will flow out of the
industry, output will decline, the price will go up and ultimately equal the cost of production.
Therefore, among different countries, resources are comparatively immobile; hence, there is an
automatic influence equalising price and costs. There may be permanent difference between the
cost of production of a commodity in one country and the price obtained in a different country
for it. For instance, the price of tea in India must, in the long run, be equal to its cost of
production in India. But in the U.K., the price of Indian tea may be permanently higher than its
cost of production in India. In this way international trade differs from home trade.
To the extent that, there are differences in factor mobility and equality of factor returns, costs and
price of goods produced and exchanged between countries as compared to those within a single
country, international trade will follow different laws. A distinct set of theories will thus, be
needed to analyse international transactions.
Heterogeneous Markets :
In the international economy, world markets lack homogeneity on account of differences in
language, preferences, customs, weights and measures, etc. The behaviour of international
buyers in each case would, therefore, be different. For instance, the Indians have right-hand
driven cars while Americans have left-hand driven cars. Hence, the markets for automobiles are

effectively separated. Thus, one peculiarity of international trade is that, it involves
heterogeneous national markets.
Different National Groups :
An obvious difference between home trade and foreign trade is that trade within a country is
trade among the same group of people, whereas, trade between countries runs between
differently cohered groups. The socio-economic environment differs greatly between nations,
while it is more or less uniform within countries. Friedrich List, therefore, put that: "Domestic
trade is among us, international trade is between us and them."
Different Political Units :
International trade is a phenomenon which occurs between politically different units, while
domestic trade occurs within the same political unit. The government in each country is keen
about the welfare of its own nationals against that of the people of other countries. Hence, in
international trade policy, each government tries to see its own interest at the cost of the other
country. As a matter of fact national sovereignty exerts its great influence on the character of
economic activity and trade.
Thus, the task of international economics is to discover a common ground, if it can, for economic
relationship which will satisfy the various components of a peaceful world.
Different National Policies and Government Intervention :
National rules, laws and policies relating to trade, commerce, industry, taxation, etc., are more or
less uniform within a country, but differ widely between countries. Tariff policy, import quota
system, subsidies and other controls adopted by a government interfere with the course of normal
trade between it and other countries. Thus, state interference causes different problems in
international trade while the value theory in its pure form, which assumes-laissez-faire policy,
cannot be applied in toto to the international trade theory.
Different Currencies :
Perhaps the principal difference between domestic and international trade is that, the latter
involves the use of different types of currencies. That is why there is the problem of exchange
rates and foreign exchange. It is a fact that different countries follow different foreign exchange
policies. Thus, one has to study not only the factors which determine the value of each country's
monetary unit, but also the fact of divergent practices and exchange resorted to.
Specific Problems :
International economic relations give rise to certain specific problems of a peculiar nature, e.g.,
international liquidity, international monetary co-operation, evolution of international
organisations like the European Common Market, etc. Such problems can never arise in regional
economics. These are to be studied separately and solved by "international economics" against
the background of world movements at large.
International Trade Theories
Introduction

In the 1600 and 1700 centuries, mercantilism stressed that countries should simultaneously
encourage exports and discourage imports. Although mercantilism is an old theory it echoes in
modern politics and trade policies of many countries. The neoclassical economist Adam Smith,
who developed the theory of absolute advantage, was the first to explain why unrestricted free
trade is beneficial to a country. Smith argued that 'the invisible hand' of the market mechanism,
rather than government policy, should determine what a country imports and what it exports.
Two theories have been developed from Adam Smith's absolute advantage theory. The first is the
English neoclassical economist David Ricardo's comparative advantage. Two Swedish
economists, Eli Hecksher and Bertil Ohlin, develop the second theory.
The Heckscher-Ohlin theory is preferred on theoretical grounds, but in real-world international
trade pattern it turned out not to be easily transferred, referred to as the Leontief paradox.
Another theory trying to explain the failure of the Hecksher-Ohlin theory of international trade
was the product life cycle theory developed by Raymond Vernon.
Mercantilism
According to Wild, 2000, the trade theory that states that nations should accumulate financial
wealth, usually in the form of gold, by encouraging exports and discouraging imports is called
mercantilism. According to this theory other measures of countries' well being, such as living
standards or human development, are irrelevant. Mainly Great Britain, France, the Netherlands,
Portugal and Spain used mercantilism during the 1500s to the late 1700s.
Mercantilistic countries practised the so-called zero-sum game, which meant that world wealth
was limited and that countries only could increase their share at expense of their neighbours. The
economic development was prevented when the mercantilistic countries paid the colonies little
for export and charged them high price for import. The main problem with mercantilism is that
all countries engaged in export but was restricted from import, another prevention from
development of international trade.
Absolute Advantage
The Scottish economist Adam Smith developed the trade theory of absolute advantage in 1776.
A country that has an absolute advantage produces greater output of a good or service than other
countries using the same amount of resources. Smith stated that tariffs and quotas should not
restrict international trade; it should be allowed to flow according to market forces. Contrary to
mercantilism Smith argued that a country should concentrate on production of goods in which it
holds an absolute advantage. No country would then need to produce all the goods it consumed.
The theory of absolute advantage destroys the mercantilistic idea that international trade is a
zero-sum game. According to the absolute advantage theory, international trade is a positive-sum
game, because there are gains for both countries to an exchange. Unlike mercantilism this theory
measures the nation's wealth by the living standards of its people and not by gold and silver.
There is a potential problem with absolute advantage. If there is one country that does not have
an absolute advantage in the production of any product, will there still be benefit to trade, and
will trade even occur? The answer may be found in the extension of absolute advantage, the
theory of comparative advantage.

Comparative Advantage
The most basic concept in the whole of international trade theory is the principle of comparative
advantage, first introduced by David Ricardo in 1817. It remains a major influence on much
international trade policy and is therefore important in understanding the modern global
economy. The principle of comparative advantage states that a country should specialise in
producing and exporting those products in which is has a comparative, or relative cost, advantage
compared with other countries and should import those goods in which it has a comparative
disadvantage. Out of such specialisation, it is argued, will accrue greater benefit for all.
In this theory there are several assumptions that limit the real-world application. The
assumption that countries are driven only by the maximisation of production and consumption,
and not by issues out of concern for workers or consumers is a mistake.
Heckscher-Ohlin Theory
In the early 1900s an international trade theory called factor proportions theory emerged by two
Swedish economists, Eli Heckscher and Bertil Ohlin. This theory is also called the Heckscher-
Ohlin theory. The Heckscher-Ohlin theory stresses that countries should produce and export
goods that require resources (factors) that are abundant and import goods that require resources
in short supply. This theory differs from the theories of comparative advantage and absolute
advantage since these theory focuses on the productivity of the production process for a
particular good. On the contrary, the Heckscher-Ohlin theory states that a country should
specialise production and export using the factors that are most abundant, and thus the cheapest.
Not produce, as earlier theories stated, the goods it produces most efficiently.
The Heckscher-Ohlin theory is preferred to the Ricardo theory by many economists, because it
makes fewer simplifying assumptions. In 1953, Wassily Leontief published a study, where he
tested the validity of the Heckscher-Ohlin theory. The study showed that the U.S was more
abundant in capital compared to other countries, therefore the U.S would export capital-
intensive goods and import labour-intensive goods. Leontief found out that the U.S's export was
less capital intensive than import.
Product Life Cycle Theory
Raymond Vernon developed the international product life cycle theory in the 1960s. The
international product life cycle theory stresses that a company will begin to export its product
and later take on foreign direct investment as the product moves through its life cycle. Eventually
a country's export becomes its import. Although the model is developed around the U.S, it can be
generalised and applied to any of the developed and innovative markets of the world.
The product life cycle theory was developed during the 1960s and focused on the U.S since
most innovations came from that market. This was an applicable theory at that time since the U.S
dominated the world trade. Today, the U.S is no longer the only innovator of products in the
world. Today companies design new products and modify them much quicker than before.
Companies are forced to introduce the products in many different markets at the same time to
gain cost benefits before its sales declines. The theory does not explain trade patterns of today.
Summary

Mercantilism proposed that a country should try to export more than it imports, in order to
receive gold. The main criticism of mercantilism is that countries are restricted from import, a
prevention of international trade. Adam Smith developed the theory of absolute advantage that
stressed that a country should produce goods or services if it uses a lesser amount of resources
than other countries. David Ricardo stated in his theory of comparative advantage that a country
should specialise in producing and exporting products in which it has a comparative advantage
and it should import goods in which it has a comparative disadvantage. Hecksher-Ohlin's theory
of factor endowments stressed that a country should produce and export goods that require
resources (factors) that are abundant in the home country. Leontief tested the Hecksher-Ohlin
theory in the U.S. and found that it was not applicable in the U.S. Raymond Vernon's product life
cycle theory stresses that a company will begin to export its product and later take on foreign
direct investment as the product moves through its life cycle. Eventually a country's export
becomes its import.
COMPARATIVE COST THEORY: DAVID RICARDO
Each country specializes in that commodity in which its comparative cost is the least .Therefore
when a country enters into trade it will export those commodity in which it’s comparative costs
are less and will import those commodities in which comparative costs are high.It follows that
each country will specialize in this commodity in which it has greatest advantage or the least
comparative advantage. The assumptions of this theory are as follows.
1. There are two countries.
2. There are two commodities.
3. There is similar taste in both the countries.
4. Labour is the only factor.
5. The supply of labour is unchanged.
6. All units of labour are homogeneous
7. Price of the two commodities are determined by labour costs.
8. Commodities are reduced under the law of constant cost.
9. Technical knowledge is unchanged.
10. Factors of production are perfectly mobile within each country but are immobile between
each country.
11. All the factors are fully employed.
12. There are no trade barriers.
Unit – II
Gains from international trade – Terms of trade – Technical progress and
Trade – Balance of Trade – Balance of Payments and Indian perspective –

Economic effects and Trade restrictions – Bilateralism – OPEC & other
international cartels.
GAINS FROM INTERNATIONAL TRADE:
1. Kind of Gains from Trade
2. Sources of Gains from Trade
3. Determinants of Gains from Trade
4. Measurement of Gains from Trade
5. Size of the Country and Gains from Trade
DEFINITION
Gains from International trade refers to that advantages which different countries
participating in international trade enjoy as a result of specialization and division of labour. The
Gains from trade are the benefits from trading rather than producing i.e. the benefits that accrue
to each country to a transaction over and above the benefits each would have derived from
producing the goods or services themselves.
KINDS OF GAINS FROM TRADE
1. STATIC GAINS: Static gains are the gains from the reallocation of factors of
production in sectors where the country has a comparative advantage. Static gains can be
reaped immediately in the short-run through more efficient allocation.
2. DYNAMIC GAINS: Dynamic gains are those gains which accumulates over a period of
time. Dynamic gains accrue only over time in less obvious and direct ways.
STATIC GAINS:
1. Maximisation of Production i.e efficiency gains from exploiting comparative advantage
2. Increase in Welfare
3. Increase in National Income
4. Reduced Costs from Economies of Scale
5. Increased Product Variety
6. Vent for Surplus
DYANAMIC GAINS FROM TRADE
1. Efficient Utilisation of Resources
2. Widening of the Market
3. Increase in Saving and Investment
4. Educational Effect (Learning by importing and learning by exporting)
5. Checking of Monopolies
6. Increase in Competition

SOURCES OF GAINS FROM INTERNATIONAL TRADE
1. Expansion of the Size of the Market
2. Division of Labour
3. Gains from Specialisation
4. Gains from Increased Product Variety
5. Gains from Increased Competition
6. Gains from Increased Economies of Scale
7. Productivity Gains
DETERMINANTS OF GAINS FROM INTERNATIONAL TRADE
1. TERMS OF TRADE: Terms of trade refers to the rate at which the goods of one country
are exchanged for the goods of another country. Country with better term of trade gains
more.
2. RECIPROCAL DEMAND: If the demand of a country for the production of another
country is inelastic, terms of trade will be unfavourable.
3. DIFFERENCE IN COST RATIOS: More the difference in the cost ratios of two
countries, more is the gain from international trade.
4. IMPROVEMENT IN PRODUCTIVITY: With improvement in productivity, costs and
prices fall in both the countries leading to enlargement of productivity gains.
5. STAGE OF DEVELOPMENT: An industrialist advanced and capital rich country
generally enjoys a larger share of the gain of trade than an economically backward and
labour-abundant country.
6. SIZE OF THE COUNTRY: Inverse relationship between size of the country and gains
from trade. A smaller country gains more from specialisation.
7. NATURE OF EXPORT GOODS: A country exporting primary goods have adverse term
of trade and gains less from trade whereas a country exporting manufacturing goods
gains more from trade.
8. TRANSPORT COSTS: High transport costs limits the gains from trade. An decrease in
transportation costs increases the gains from trade.
9. COMPETITION AND MONOPOLY: Goods having production in many countries faces
more competition and hence the gains from trade will be less to the countries exporting
these goods.
MEASUREMENT OF GAINS FROM INTERNATIONAL TRADE
TRADITIONAL VIEW
1. Reduction in Production Costs (Ricardo Approach)
2. Terms of Trade (Mills Approach)

3. Increase in Real Income
MODERN VIEW
RICARDO APPROACH FOR MEASUREMENT OF GAINS
Reduction in the total real costs is the basis of gains.
A country will export those commodities in which its comparative production costs are less and
will import those commodities in which comparative production costs are high.
The country thus economises in the use of its resources, obtaining for a given amount thereof a
larger total income than if it attempted to produce everything at home. The difference between
the two is its gain from trade .
Y- A1 A THE AMOUNT OF GAIN FROM TRADE IS
COMMODI A BB1/OB
TY E
B B1
O
X-COMMODITY
O X - Commodity Y - Commodity A B C . E . F A` B` Before Trade: AB is the PPC curve of the
country. Point E indicates equilibrium position before trade. After Trade: PPC shifts and take the
shape of BC. Slope of BC shows international price ratio. Suppose the country is in equilibrium
at point F on BC curve, then to produce there it would have to increase its labour such as to shift
its PPC to A`B` The amount of gains from trade will be BB`/OB
G A 0 B 0 Malthus criticised that Ricardo has greatly over-estimated the gains. He argued that F
will not be the equilibrium point. He opined that consumer will prefer a point right of F on A`B`.
CI Findlay has modified gains from trade by introducing indifference curve CI. If the labour
input is increased sufficiently to push PPC to A 0 B 0 instead of A`B`, the point G on CI will
give equal satisfaction as in F. The amount of gains from trade will be BB 0 /OB .

C
A1
A2 F
C1
Y-
A
COMMODITY
A G
B B2 B1
X -COMMODITY
J.S. MILL APPROACH
The Ricardo analysis does not show the exact position of quantum of gains and how they
are distributed.
John Stuart Mill had resolved the problem of how to exactly reach the rate of exchange in
international market.
According to Mills it is the reciprocal demand that actually determines the prevailing terms of
trade and the gains obtained by a particular country.
In his view import, or in other words , demand, must be of much more importance than export in
determining the real terms of trade.
When a country participate trade it firstly takes the status as a demander. Another status
of a trader, supplier, is just derived there from. It is the relative extensibility of reciprocal
demand that actually determines the real terms of trade and consequently the distribution of
possible total gains from trade between the two trade partners. Suppose India has a comparative
advantage in wheat and enormous demand for auto. And U.S.A. has a comparative advantage in
auto and enormous demand for wheat.
The equilibrium terms of trade depend on both Indian demand for auto and wheat as well as
U.S.A. demand for these two goods.
If the Indian demand for auto is stronger, term of trade will be close to Indian price ratio. And if
the US demand for wheat is stronger, terms of trade will be close to US price ratio.
REAL INCOME APPROACH
Instead of importing goods from abroad, if the same are produced and consumed within
the country, then the relative loss suffered by the country will constitute the basis for measuring
gains from trade. This would be maximum gains.

On the other hand, if the goods received from international trade are consumed in same ratio as
when the same are produced with in the country, then the resulting increase in income will be the
minimum gains from trade.
Real gains from trade is always between these maximum and minimum gains.
MODERN APPROACH
Modern Theory divides the gains from trade into gains from production and gains from
consumption . The theory states that the introduction of trade permits the realisation of gain from
exchange and gain from specialisation. Both consumers and producers gain from international
trade by consuming more and producing more than the pre-trade level.
SIZE OF THE COUNTRY AND GAINS FROM TRADE
1. Gains from trade are relatively larger for a small country.
2. Owning to small size, the scope of gains from specialisation and exchange are limited
whereas large country has scope for both.
3. Trade provide an opportunity for the small country to specialise in the production of
those commodities in which it has comparative advantage and exchange them in world
market.
4. The more world market prices differ from domestic market, more will be its gains.
In international economics and international trade, terms of trade or TOT is (Price
Exports)/(Price Imports). In layman's terms it means what quantity of imports can be
purchased through the sale of a fixed quantity of exports. "Terms of trade" are sometimes
used as a proxy for the relative social welfare of a country, but this heuristic is technically
questionable and should be used with extreme caution. An improvement in a nation's terms
of trade (the increase of the ratio) is good for that country in the sense that it can buy more
imports for any given level of exports. The terms of trade is influenced by the exchange rate
because a rise in the value of a country's currency lowers the domestic prices for its imports
but does not directly affect the commodities it produces (i.e. its exports).
Terms of trade
In international economics and international trade, terms of trade or TOT is (Price of
exportable goods)/(Price of importable goods). In layman's terms it means what quantity of
imports can be purchased through the sale of a fixed quantity of exports. "Terms of trade" are
sometimes used as a proxy for the relative social welfare of a country, but this heuristic is
technically questionable and should be used with extreme caution. An improvement in a nation's
terms of trade (the increase of the ratio) is good for that country in the sense that it can buy more
imports for any given level of exports. The terms of trade is influenced by the exchange rate

because a rise in the value of a country's currency lowers the domestic prices for its imports but
does not directly affect the commodities it produces (i.e. its exports).
Two country model CIE economics
In the simplified case of two countries and two commodities, terms of trade is defined as the
ratio of the total export revenue[clarification needed] a country receives for its export commodity to the
total import revenue it pays for its import commodity. In this case the imports of one country are
the exports of the other country. For example, if a country exports 50 dollars worth of product in
exchange for 100 dollars worth of imported product, that country's terms of trade are 50/100 =
0.5. The terms of trade for the other country must be the reciprocal (100/50 = 2). When this
number is falling, the country is said to have "deteriorating terms of trade". If multiplied by 100,
these calculations can be expressed as a percentage (50% and 200% respectively). If a country's
terms of trade fall from say 100% to 70% (from 1.0 to 0.7), it has experienced a 30%
deterioration in its terms of trade. When doing longitudinal (time series) calculations, it is
common to set a value for the base year[citation needed] to make interpretation of the results easier.
In basic Microeconomics, the terms of trade are usually set in the interval between the
opportunity costs for the production of a given good of two countries.
Terms of trade is the ratio of a country's export price index to its import price index, multiplied
by 100. The terms of trade measures the rate of exchange of one good or service for another
when two countries trade with each other.
Multi-commodity multi-country model
In the more realistic case of many products exchanged between many countries, terms of trade
can be calculated using a Laspeyres index. In this case, a nation's terms of trade is the ratio of the
Laspeyre price index of exports to the Laspeyre price index of imports. The Laspeyre export
index is the current value of the base period exports divided by the base period value of the base
period exports. Similarly, the Laspeyres import index is the current value of the base period
imports divided by the base period value of the base period imports.
Where
price of exports in the current period
quantity of exports in the base period
price of exports in the base period
price of imports in the current period
quantity of imports in the base period
price of imports in the base period
Basically: Export Price Over Import price times 100 If the percentage is over 100% then your
economy is doing well (Capital Accumulation). If the percentage is under 100% then your
economy is not going well (More money going out than coming in).

Technical Progress of a Country and International Trade
The modern world is a highly mechanised world. It is shaped by technical progress. The
rapid progress of modern economic societies has become possible due to changes caused by
technological and scientific progress.
It must, however, be recognised that, technical progress can affect the volume and mode of
international trade to a great extent. As technical progress influences the composition of
production function, relative cost-price structure, demand pattern use of resources, so on and so
forth, its effect on foreign trade is also bound to be very significant.
Forms of Technical Progress :
(i) Natural Technical Progress :
It refers to a neutral innovation - a new process of production. As Hicks put it, in a two-factor
production function (say, labour and capital inputs). The effect of neutral innovation is to raise
the marginal productivity of both the factors - labour and capital - in the same proportion. Thus,
neutral technical progress keeps the relationship between labour and capital unaffected.
(ii) Labour-saving Technical Progress :
Using Hicksian criterion, labour-saving technical progress may be defined as that kind of
technical improvement and change in the process of production which increases the marginal
productivity of labour relatively to that of capital. Under labour-saving innovation, the
production function is modified with an increasing quantity of capital and reduced input of
labour.
(iii) Capital-saving Technical Progress :
It refers to that new process which tends to increase the marginal productivity of c relatively to
that of labour. The effect of capital-saving innovation on the production function is to reduce the
input of capital and increase the quantum of labour.
Technical Progress and Terms of Trades
Technical progress can affect the terms of trade of a country by influencing the productivity
factory inputs. How it reacts we shall analyze below.
Different forms of technical progress will affect the terms of trade and foreign trade of country in
different ways.
Effect of Neutral Technical Progress
A general hypothesis may be laid down that, if neutral technical progress takes place in export
sector of a country, the country's terms of trade may deteriorate, while technological pro in the
import substitutions of the country will help the country to improve its terms of trade.
To explain this phenomenon, let us assume a two-factor, two-good, two-country model, say
countries A and B have factors labour (L) and capital (K), and produce goods X and Y. Assume
the product X is labour-intensive and F capital-intensive.
When neutral technical progress takes place in Y industry, the isoquant downward, its slope
renaming unchanged. This implies that, due to a proportional rise in the productivities of labour
and capital, less input of both these factors will be needed to produce the same outputs of Y. If
factor prices are unchanged: P1 /IP0, the same factor proportions Used in the production function

as before. But if the same commodity prices are to be maintained, Factor prices will have to be
changed. The new factor-price ratio is obtained by drawing a New factor-price line p2 tangent to
the new y'y' isoquant the old xx isoquant. This is reflected in a rise in the relative prices of
capital in the Y industry. This is due to the fact that as producers find increased productivity of
capital and want to produce of Y the demand for capital tend to increase leading to a rise in the
price of capital. But when capital becomes costly, the producers will resort to Labour-intensive
techniques in both the industries X and Y. The new ratio of factor-proportions in the production
function is, thus, shown by OZ' in Y and OM' in X. Induced by technical progress in the Y
industry, when the country produces more of Y with labour-intensive method, the labour input in
X decreases, so the output of X contracts. At the constant commodity price, therefore, there will
be an excess demand for X Consequently, the price of X will rise and that of Y will tend to fall
(caused by its increased supply).
Now, if Y happens to be the country's exportable goods and X its importable goods, the terms of
trade of the country will be settled unfavourably on account of the rising domestic price of Y
(exportable), leading to contraction in its foreign demand and increasing domestic demand for X,
resulting in its high import demand. In this event, the offer curve of the country will shift
towards the exportable axis offering more amount of exportable for a given unit of importable.
If, however, Y is an import substitute, technical progress in this line will improve the bargaining
position of the country so its terms of trade will also improve.
However, the direction in the charge of the terms of trade caused by neutral innovation depends
more on elasticities of demand for exports and imports, along with other factors. If the income
elasticity of demand for importable goods is less than unity, the deterioration in terms of trade
will be less in the unfavorable case and improvement in terms of trade will be more in the
favourable case.
Effect of Capital-saving Technical Progress
The basic hypothesis is that capital-saving technological progress will lead to unfavourable terms
of trade in a country if its exportables belong to the capital-intensive line of production. If
technical progress relates to the import substitution industry (which belongs to the capital-
intensive sector), the terms of trade will improve on account of the capital-saving innovation.
To explain this phenomenon, in our illustration model, when capital-saving innovation occurs,
the marginal productivity of labour improves; so at unchanged factor prices, the method of
production will tend to be more labour-intensive.
If commodity prices are to be kept constant, factor prices must change in favour of capital, so
capital has become more dear, producers will resort to labour-intensive techniques in both the
lines of production. Since income expands due to increased productivity caused by technological
progress, demand for X and Y will tend to increase.
At a constant price therefore, demand for X will be in excess in relation to its supply, assist
supply decreases in the process of transferring more labour to Y industry. The price of X will
thus rise. Thus, if Y is exportable, the terms of trade will go against the country. If Y is an import
substitute, then the country's terms of trade will tend to improve.

Effect of Labour-saving Innovation
In the case of a labour-saving technological progress in a capital-intensive industry, we cannot
visualise any determinate effect on the terms of trade, as the relative price of the innovating good
might increase or decrease, so on precise theoretical inference is possible.
In the geometric model, when labour-saving technical progress occurs in the case of Y industry,
the new isoquant will be y'y' with a changed slope along with, the shift towards origin.
Then, the price of capital (PK) must rise. Because, when technological innovation occurs in the
Y (capital-intensive) sector, producers will be inclined to produce more of Y, as such the demand
for AT will rise. Further, in a labour-saving innovation capital productivity rises, so also the
demand for capital rises, which causes PK to rise. The new factor price line P is derived thus.
New Equilibrium points are Z' and M. It appears that ~ ratio falls in A" industry, though, there is
no technical progress (but on account of the high price of capital, labour-intensive method is
adopted). However, the marginal productivity of capital improves because of labour-saving
technical progress, so the producers may be induced to adopt capital-intensive technique of
production. The stronger this tendency, the greater will be the use made of the capital-intensive
method, despite its high cost.
But if innovation were to lower the costs still further, as is seen from y "y" isoquant, the story
would be different. Then, the new factor price line will be p2, which means a very high cost of
capital relative to labour. In the X industry, then, labour-intensive method will be adopted (see
equilibrium point M"). Similarly, the equilibrium point Z" indicates that in Y industry also, more
labour-intensive technique will be used, despite the improved marginal productivity of capital.
In short, labour-saving technical progress in the capital-intensive sector will cause an increase
In the relative price of capital to that of labour and ratio will fall in the labour-intensive
production sector. A high ratio in capital-intensive industry will mean a decrease in Y product;
but a low Ratio in labour-intensive industry will mean an increase in the production of X at
constant prices. Thus, there will be excess demand for 7(caused by rising income and contracting
output), the price of Y- (Py) will rise in relation to the price of X- (Px). If, however, reduction in
costs cause by innovation is high the reverse will happen. So, we cannot arrive at a determinate
conclusion this regard.
To recapitulate, technical progress affects the marginal productivities of factors of production.
When the r productivity of a factor rises on account of innovation, a greater proportion of this
factor will be employed in the innovating industry than in a non-innovating industry. Hence,
reallocation of factors depends on the change in t absolute value of the marginal productivities.
As Bo Sodersten concludes: "When technological progress increases the marginal productivities
of both the factors (in a. two-factoral production function), the effects on output and relative
prices, and terms of trade are clearly determinate. But if the marginal productivity of one of the
factors or both the factors falls, then the resulting phenomenon about terms of trade cannot be
firmly determined.
Bo Sodersten also states that technical progress in the import substitution field will always have
a positive effect on the real income of the country. If it is so in the case of the export sector, and

the marginal productivities of factors are decreased by innovation, then only will it have a
positive effect on the national income. But an increased marginal productivity caused by the
export-oriented innovation produces a negative effect on real income.
Balance of trade
The balance of trade, or net exports (sometimes symbolized as NX), is the difference
between the monetary value of exports and imports of output in an economy over a certain
period. It is the relationship between a nation's imports and exports.[1][dead link] A positive balance
is known as a trade surplus if it consists of exporting more than is imported; a negative balance is
referred to as a trade deficit or, informally, a trade gap. The balance of trade is sometimes
divided into a goods and a services balance.
Early understanding of the functioning of balance of trade informed the economic policies of
Early Modern Europe that are grouped under the heading mercantilism. An early statement
appeared in Discourse of the Common Wealth of this Realm of England, 1549: "We must always
take heed that we buy no more from strangers than we sell them, for so should we impoverish
ourselves and enrich them."[2] Similarly a systematic and coherent explanation of balance of
trade was made public through Thomas Mun's c1630 "England's treasure by forraign trade, or,
The balance of our forraign trade is the rule of our treasure"[3]
Definition
The balance of trade forms part of the current account, which includes other transactions
such as income from the international investment position as well as international aid. If the
current account is in surplus, the country's net international asset position increases
correspondingly. Equally, a deficit decreases the net international asset position.
The trade balance is identical to the difference between a country's output and its domestic
demand (the difference between what goods a country produces and how many goods it buys
from abroad; this does not include money re-spent on foreign stock, nor does it factor in the
concept of importing goods to produce for the domestic market).
Measuring the balance of trade can be problematic because of problems with recording and
collecting data. As an illustration of this problem, when official data for all the world's countries
are added up, exports exceed imports by almost 1%; it appears the world is running a positive
balance of trade with itself. This cannot be true, because all transactions involve an equal credit
or debit in the account of each nation. The discrepancy is widely believed to be explained by
transactions intended to launder money or evade taxes, smuggling and other visibility problems.
However, especially for developed countries, accuracy is likely.
Factors that can affect the balance of trade include:
The cost of production (land, labor, capital, taxes, incentives, etc.) in the exporting
economy vis-à-vis those in the importing economy;
The cost and availability of raw materials, intermediate goods and other inputs;
Exchange rate movements;

Multilateral, bilateral and unilateral taxes or restrictions on trade;
Non-tariff barriers such as environmental, health or safety standards;
The availability of adequate foreign exchange with which to pay for imports; and
Prices of goods manufactured at home (influenced by the responsiveness of supply)
In addition, the trade balance is likely to differ across the business cycle. In export-led
growth (such as oil and early industrial goods), the balance of trade will improve during
an economic expansion. However, with domestic demand led growth (as in the United
States and Australia) the trade balance will worsen at the same stage in the business
cycle.
Since the mid 1980s, the United States has had a growing deficit in tradeable goods,
especially with Asian nations (China and Japan) which now hold large sums of U.S debt
that has funded the consumption.[4][5] The U.S. has a trade surplus with nations such as
Australia. The issue of trade deficits can be complex. Trade deficits generated in
tradeable goods such as manufactured goods or software may impact domestic
employment to different degrees than trade deficits in raw materials.
Economies such as Canada, Japan, and Germany which have savings surpluses, typically
run trade surpluses. China, a high growth economy, has tended to run trade surpluses. A
higher savings rate generally corresponds to a trade surplus. Correspondingly, the U.S.
with its lower savings rate has tended to run high trade deficits, especially with Asian
nations.
Main Components of India's Balance of Payments
1. Trade Balance
Trade balance was in deficit through out the period shown in the table as imports always
exceeded the exports. Within the imports the POL items constituting a sizeable position
continued to increase throughout. Exports did not achieve the required growth rate. Trade deficit
in 2005-06 stood at $ -51,841 billion US $.
2. Current Account
Current account balance includes visible items (trade balance) and invisibles is in a more
encouraging position. It declined to $ -2,666 million in 2000-01 from $-9680 million in 1990-91
and recorded a surplus in 2003-04 to the extent of $ 14,083 million. In 2005-06, once again there
was a deficit of $ 9,186 million. The main reason for the improvement during 2001-05 was the
success of invisible items.
3. Invisible
The impressive role placed by invisibles in covering trade deficit is due to sharp rise
invisible receipts. The main contributing factor to rise in invisible receipts are non factor receipts
and private transfers. As far as non factor services receipts are concerned the main development
has been the rapid increase in the exports of software services. As far as private transfers are
concerned their main constituent is workers remittance from abroad. During this period the
private transfer receipts also increased from $ 2,069 million in 1990-91 to $ 24,102 million in

2005-06. The current trend of outsourcing a number of jobs by the developed countries to the
developing ones is also helping us to get more jobs and earn additional foreign exchange.
4. Capital Account
Capital account has been positive throughout the period. NRI deposits and foreign
investment both portfolio and direct have helped to a great extent. The main reasons for huge
increase in capital account is due to large capital inflows on account of Foreign direct investment
(FDI); Foreign Institutional Investors (FIIs) investment on the stock markets and also by way of
Euro equities raised by Indian firms. The Non-resident deposit also forms a part of capital
account.
5. Reserves
Reserves have changed during this period depending on a balance between current and
capital account. An increase in inflow under capital account has helped us to build up our foreign
exchange reserve making the country quiet comfortable on this count. In April 2007 we had $
203 billion foreign exchangereserves.
The year 2005-06 registered the highest trade deficit so far running into $ 51,841 million,
because of rising Oil prices; As a result despite impressive positive earnings of as much as $
42,655 million from invisibles, the current account deficit in this year was $ 9,189 million which
is 1.1% of GDP.
Conclusion
The balance of payment situation started improving since 1992-93. There was a
satisfactory balance of payment position in that period; the reasons are (i) High earnings from
invisibles, (ii) Rise in external commercial borrowings, and (iii) Encouragement to foreign direct
investment.
The positive earnings from invisibles covered a substantial part of trade deficit and
current account deficit reduced significantly. The external commercial borrowings was
extensively used to finance the current account deficit. The net non resident deposits were
positive through out the ten year period. There has been a growing strength in India's balance of
payment position in the post reform period inspite of growing trade deficit and current account
deficit.
COMPARATIVE ANALYSIS OF BALANCE OF
PAYMENTS: INDIAN PERSPECTIVE
The balance of payments of a country is a systematic record of all transactions between
the residents of a country and the rest of the world carried out in a specific period of time.
Balance of payments (BOP) accounts are an accounting record of all monetary transactions
between a country and the rest of the world. These transactions include payments for the
country's exports and imports of goods, services, financial capital, and financial transfers. The
BOP accounts summarize international transactions for a specific period, usually a year, and are
prepared in a single currency, typically the domestic currency for the country concerned. Sources
of funds for a nation, such as exports or the receipts of loans and investments, are recorded as
positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are

recorded as negative or deficit items. When all components of the BOP accounts are included
they must sum to zero with no overall surplus or deficit. For example, if a country is importing
more than it exports, its trade balance will be in deficit, but the shortfall will have to be counter-
balanced in other ways – such as by funds earned from its foreign investments, by running down
central bank reserves or by receiving loans from other countries.
While the overall BOP accounts will always balance when all types of payments are included,
imbalances are possible on individual elements of the BOP, such as the current account, the
capital account excluding the central bank's reserve account, or the sum of the two. Imbalances
in the latter sum can result in surplus countries accumulating wealth, while deficit nations
become increasingly indebted. The term "balance of payments" often refers to this sum: a
country's balance of payments is said to be in surplus (equivalently, the balance of payments is
positive) by a certain amount if sources of funds (such as export goods sold and bonds sold)
exceed uses of funds (such as paying for imported goods and paying for foreign bonds
purchased) by that amount. There is said to be a balance of payments deficit (the balance of
payments is said to be negative) if the former are less than the latter.
Under a fixed exchange rate system, the central bank accommodates those flows by buying up
any net inflow of funds into the country or by providing foreign currency funds to the foreign
exchange market to match any international outflow of funds, thus preventing the funds flows
from affecting the exchange rate between the country's currency and other currencies. Then the
net change per year in the central bank's foreign exchange reserves is sometimes called the
balance of payments surplus or deficit. Alternatives to a fixed exchange rate system include a
managed float where some changes of exchange rates are allowed, or at the other extreme
apurely floating exchange rate (also known as a purely flexible exchange rate). With a pure float
The central bank does not intervene at all to protect or devalue its currency, allowing the rate to
be set by the market, and the central bank's foreign exchange reserves do not change. Historically
there have been different approaches to the question of how or even whether to eliminate current
account or trade imbalances. With record trade imbalances held up as one of the contributing
factors to the financial crisis of 2007–2010, plans to address global imbalances have been high
on the agenda of policy makers since 2009. India's balance of payment worsened in the early
1990's but now the situation is under control. In fact, India has a good foreign exchange reserves
mainly due to capital inflows from foreign financial institutions or the stock exchange.
CONCEPT OF BALANCE OF PAYMENT
The two principal parts of the BOP accounts are the current account and the capital
account. The current account shows the net amount a country is earning if it is in surplus, or
spending if it is in deficit. It is the sum of the balance of trade (net earnings on exports minus
payments for imports), factor income (earnings on foreign investments minus payments made to
foreign investors) and cash transfers. It is called the current account as it covers transactions in

the "here and now" - those that don't give rise to future claims. The capital account records the
net change in ownership of foreign assets. It includes the reserve account (the foreign exchange
market operations of a nation's central bank), along with loans and investments between the
country and the rest of world (but not the future regular repayments/dividends that the loans and
investments yield; those are earnings and will be recorded in the current account). The term
"capital account" is also used in the narrower sense that excludes central bank foreign exchange
market operations: Sometimes the reserve account is classified as "below the line" and so no
reported as part of the capital account. Expressed with the broader meaning for the capital
account, the BOP identity assumes that any current account surplus will be balanced by a capital
account deficit of equal size – or alternatively a current account deficit will be balanced by a
corresponding capital account surplus: current account + broadly defined capital account
+balancing item+0 . The balancing item which may be positive or negative is simply an amount
that accounts for any statistical errors and assures that the current and capital accounts sum to
zero. By the principles of double entry accounting, an entry in the current account gives rise to
an entry in the capital account, and in aggregate the two accounts automatically balance. A
balance isn't always reflected in reported figures for the current and capital accounts, which
might, for example, report a surplus for both accounts, but when this happens it always means
something has been missed most commonly, the operations of the country's central bank and
what has been missed is recorded in the statistical discrepancy term (the balancing item).
The International Monetary Fund (IMF) use a particular set of definitions for the BOP
accounts, which is also used by the Organisation for Economic Cooperation and Development
(OECD), and the United Nations System of National Accounts (SNA). The main difference in
the IMF's terminology is that it uses the term "financial account" to capture transactions that
would under alternative definitions be recorded in the capital account. The IMF uses the term
capital account to designate a subset of transactions that, according to other usage, form a small
part of the overall capital account. The IMF separates these transactions out to form an additional
top level division of the BOP accounts. The IMF uses the term current account with the same
meaning as that used by other organizations, although it has its own names for its three leading
subdivisions, which are:
The goods and services account (the overall trade balance)
The primary income account (factor income such as from loans and investments)
The secondary income account (transfer payments)
REVIEW WORK ON INDIA’S BALANCE OF PAYMENTS
During the quarter of April-June 2011, the trade deficit rose by 9.7% to USD 35.4 billion,
despite a sharp increase in exports relative to imports. Export goods recorded growth of 47.1%
year-on-year (YOY), and imports registered a 33.2% YoY growth during the quarter. In absolute
terms, the trade deficit increased by USD 3.1 billion from USD 32.3 billion in the corresponding
quarter previous year. Meanwhile, net exports of services rose by 19.1% in the quarter, mainly

due to higher growth in receipts led by the transportation, construction, insurance and pension,
telecommunication, computer and information sectors. Driven by higher commodity prices, the
current account deficit (CAD) widened by 17.4% YoY to USD 14.1 billion during the first
quarter of the current fiscal year. This wider CAD was financed by an overall capital and
financial accounts surplus in excess of USD 15.4 billion during the same period. Mainly due to
increasing net foreign direct investment (FDI) inflows to India, net financial inflows increased
20.4% to USD 15.7 billion in the quarter compared to the previous year. FDI inflows increased
to USD 7.2 billion during the first quarter of fiscal year 2011-2012 as compared to USD 2.9
billion last year. There was a net accretion to foreign exchange reserves to the tune of USD 5.4
billion reflecting depreciation of the U.S. dollar against major international currencies during the
quarter.
The RBI’s latest presentation of the trade deficit patterns is decomposed into specific
current account components with detailed breakdowns on trade of goods, services, and income
transfers. In line with current international standards, the new BPM6 classifications enhance
India’s BoP statistics with more detail and better cross-country comparisons. India could not
insulate itself from the adverse developments in the international financial markets, despite
having a banking and financial system that had little to do with investments in structured
financial instruments carved out of subprime mortgages, whose failure had set off the chain of
events culminating in a global crisis. Economic growth decelerated in 2008-09 to 6.7 percent.
This represented a decline of 2.1 percent from the average growth rate of 8.8 percent in the
previous five years (2003-04 to 2007-08). Per capita GDP growth grew by an estimated 4.6
percent in 2008-09. Though this represents a substantial slowdown from the average growth of
7.3 percent per annum during the previous five years, it is still significantly higher than the
average 3.3 percent per annum income growth during 1998-99 to 2002-03. The effect of the
crisis on the Indian economy was not significant in the beginning. The initial effect of the
subprime crisis was, in fact, positive, as the country received accelerated Foreign Institutional
Investment (FII) flows during September 2007 to January 2008. There was a general belief at
this time that the emerging economies could remain largely insulated from the crisis and provide
an alternative engine of growth to the world economy. The argument soon proved unfounded as
the global crisis intensified and spread to the emerging economies through capital and current
account of the balance of payments. The net portfolio flows to India soon turned negative as
Foreign Institutional Investors rushed to sell equity stakes in a bid to replenish overseas cash
balances. This had a knock-on effect on the stock market and the exchange rates through creating
the supply demand imbalance in the foreign exchange market. The current account was affected
mainly after September 2008 through slowdown in exports. Despite setbacks, however, the BoP
situation of the country continues to remain resilient. The challenges that confronted the Indian
economy in 2008-09 and continue to do so in 2009- 10 fall into two categories - the short-term
macroeconomic challenges of monetary and fiscal policy and the medium-term challenge of
attaining and sustaining high rates of economic growth. The former covers issues such as the

trade-off between inflation and growth, the use of monetary policy versus use of fiscal policy,
their relative effectiveness and coordination between the two.
The latter includes the tension between short- and long-term fiscal policy, the immediate longer
term imperatives of monetary policy and the policy and institutional reforms necessary for
restoring high growth.
India’s balance of payments in 2008-09 captured the spread of the global crisis to India. The
current account deficit during 2008-09 shot up to 2.6 percent of GDP from 1.5 percent of GDP in
2007-08 (Table 1). And this is the highest level of current account deficit for India since 1990-
91. The capital account surplus dropped from a record high of 9.3 percent of GDP in 2007-08 to
0.9 percent of GDP. And this is lowest level of capital account surplus since 1981- 82. The year
ended with a decline in reserves of US$ 20.1 billion (inclusive of valuation changes) against a
record rise in reserves of US$ 92.2 billion for 2007-08. The global financial crisis began to affect
India from early 2008 through a withdrawal of capital from India’s financial markets. This is
shown in India’s balance of payments as a substantial decline in net capital inflows in the first
half of 2008-09 to US$ 19 billion from US$ 51.4 billion in the first half of 2007-08, a 63 percent
decline. This is seen from a large outflow of portfolio investment (as equity disinvestment by
foreign institutional investors); and lower external commercial borrowings, short-term trade
credit, and short-term bank borrowings. Inflows under foreign direct investment, external
assistance and NRI deposits, by contrast, surged during the first half of 2008-09.
IMBALANCES
While the BOP has to balance overall, surpluses or deficits on its individual elements can
lead to imbalances between countries. In general there is concern over deficits in the current
account. Countries with deficits in their current accounts will build up increasing debt and/or see
increased foreign ownership of their assets.
The types of deficits that typically raise concern are:
A visible trade deficit where a nation is importing more physical goods than it exports
(even if this is balanced by the other components of the current account.)
An overall current account deficit.
A basic deficit which is the current account plus foreign direct investment (but excluding
other elements of the capital account like short terms loans and the reserve account.
As discussed in the history section below, the Washington Consensus period saw a swing
of opinion towards the view that there is no need to worry about imbalances. Opinion
swung back in the opposite direction in the wake of financial crisis of 2007–2009.
Mainstream opinion expressed by the leading financial press and economists,
international bodies like the IMF—as well as leaders of surplus and deficit countries—
has returned to the view that large current account imbalances do matter. Some
economists do, however, remain relatively unconcerned about imbalances and there have

been assertions, such as by Michael P. Dooley, David Folkerts-Landau and Peter Garber,
that nations need to avoid temptation to switch to protectionism as a means to correct
imbalances.
CAUSES OF BOP IMBALANCES
There are conflicting views as to the primary cause of BOP imbalances, with much attention on
the US which currently has by far the biggest deficit. The conventional view is those current
accounts factors are the primary causes these include the exchange rate, the government's fiscal
deficit, business competitiveness, and private behaviour such as the willingness of consumers to
go into debt to finance extra consumption. An alternative view, argued at length in a 2005 paper
by Ben Bernanke, is that the primary driver is the capital account, where a global savings glut
caused by savers in surplus countries, runs ahead of the available investment opportunities, and
is pushed into the US resulting in excess consumption and asset price inflation.
IMPROVEMENT IN THE EXCHANGE RATE
The exchange rate policy in recent years has been guided by the broad principles of monitoring
and management of exchange rates with flexibility, without a fixed or a preannounced target or
As of April 2010 a band, while allowing the underlying demand and supply conditions to
determine the exchange rate movements of the Indian rupee over a period in an orderly manner.
Subject to this predominant objective, the RBI’s intervention in the foreign exchange market has
been driven by the objectives of reducing excess volatility, maintaining adequate level of
reserves, and developing an orderly foreign exchange market. The surge in the supply of foreign
currency in the domestic market led inevitably to a rise in the price of the rupee. The rupee
gradually appreciated from Rs. 46.54 per US dollar in August 2006 to Rs.39.37 in January 2008,
a movement that had begun to affect profitability and competitiveness of the export sector. The
global financial crisis however reversed the rupee appreciation and after the end of positive
shock around January 2008, rupee began a slow decline.
A major factor, which affected the emerging economies almost simultaneously, was the
unwinding of stock positions by the FIIs to replenish cash balances abroad. The decline in rupee
became more pronounced after the fall of Lehman Brothers in September 2008, requiring RBI
intervention to reduce volatility. It is pertinent to note that a substantial part of the movement in
the rupee-US dollar rate during this period has been a reflection of the movement of the dollar
against a basket of currencies. The rupee stabilized after October 2008, with some volatility.
With signs of recovery and return of foreign institutional investment (FII) flows after March
2009, the rupee has again been strengthening against the US dollar. For the year as a whole, the
nominal value of the rupee declined from Rs. 40.36 per US dollar in March 2008 to Rs. 51.23 per
US dollar in March 2009, reflecting 21 percent depreciation during the fiscal 2008/09. In fiscal
2009/10, however, with the signs of recovery and return of FII flows after March 2009, the rupee
has been strengthening against the US dollar. The movement of the exchange rate in the year
2009/10 indicated that the average monthly exchange rate of the rupee against the US dollar

appreciated by 9.9 percent from Rs 51.23 per US dollar in March 2009 to Rs 46.63 per US dollar
in December 2009, mainly on account of weakening of the US dollar in the international market.
ECONOMIC GROWTH
From all accounts, except for the agricultural sector as noted above, economic recovery
seems to be well underway. Economic growth stood at 7 percent during the first half of the
current fiscal year and the advance estimates for GDP growth for 2009-10 is 7.2 percent. The
recovery in GDP growth for 2009-10, as indicated in the advance estimates, is broad based.
Seven out of eight sectors/sub-sectors show a growth rate of 6.5 percent or higher. The
exception, as of April 2010 anticipated, is agriculture and allied sectors where the growth rate is
estimated to be minus 0.2 percent over 2008-09. Sectors including mining and quarrying;
manufacturing; and electricity, gas and water supply have significantly improved their growth
rates at over 8 percent in comparison with 2008-09. When compared to countries across the
world, India stands out as one of the best performing economies. Although there is a clear
moderation in growth from 9 percent levels to 7+ percent, the pace still makes India the fastest
growing major economy after the People’s Republic of China.
BILATERALISM:
Bilateralism consists of the political, economic, or cultural relations between
two sovereign states.
BILATERAL AND MULTILATERAL INTERACTIONS
From the foregoing discussion it becomes apparent that any decisive presumption in
favor of multilateralism or bilateralism would over reach, both normatively and descriptively,
and would stand the chance of being self defeating for either side of the universalist/unilateralist
debate. The relative merits of multilateral and bilateral regimes come into view only upon a more
nuanced examination of different kinds of international cooperation across a variety of subject
matters. The environment, trade and investment, human rights, diplomatic immunities, the sea
and the moon, resource sharing, transport and telecommunication, health, and education are all,
in the context of treaties, different types of ―goods‖ that necessitate different types of
international cooperation, lending themselves more naturally to different types of regulatory
regimes. Values such as promoting the rule of law, equality, effectiveness, and democratic
legitimacy may all be advanced through MLTs but may, at times, be better realized through more
limited forms of cooperation.
No less importantly, neither MLTs nor BLTs operate in a vacuum. All treaties are
buildings or structures in the overall architecture of international law. Or, to use Joseph Weiler’s
metaphor, bilateralism and multilateralism are but two strata in the more complex geology of
international law. Viewing each structure on its own closes off from view the myriad ways in
which they interact with one another: how they complement, enrich, and strengthen one another,
and also how they might inhibit or obstruct one another. Understanding the full scale of

interaction makes the choice between designing BLTs or MLTs at any particular moment even
more consequential. Although the previous sections have already alluded to some possible
interactions, the following section is dedicated to their systematic exposition.
First, in their simplest and most elemental form, BLTs fully reproduce multilaterally designed
legal rules, merely repeating the latter to reinforce them in the bilateral context. Such repetition
is not redundant. Dyads of countries may wish to conclude bilateral agreements for symbolic
reasons, emphasizing their intent to abide by an already multilaterally assumed commitment
toward one another in particular. India and Pakistan, for instance, concluded a bilateral
agreement on the treatment of their respective diplomatic and consular staff, even though both
countries were already parties to the corresponding multilateral Vienna conventions.
The fact that the agreement was signed amidst an enduring conflict between the two countries
gave the bilateral agreement a special political and normative clout, which the Vienna
conventions did not have.
Another reason to reproduce a multilateral commitment in a bilateral instrument is the
belief that the pledge would carry more weight in the bilateral setting, where retaliation for
violations is potentially more immediate and precise. The pre-existence of the multilateral norm
makes it easier to repeat in the bilateral agreement. It is also possible that the multilateral rule,
with its existing body of accepted practical application and interpretation may then operate to
stabilize and reinforce the bilateral agreement.
Organization of Petroleum Exporting Countries
OPEC is an intergovernmental organization of twelve oil-producing countries made up
of Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United
Arab Emirates, and Venezuela. OPEC has maintained its headquarters in Vienna since 1965, and
hosts regular meetings among the oil ministers of its Member Countries. It is considered to be
one of the most effective organizations in the world. Indonesia withdrew in 2008 after it became
a net importer of oil, but stated it would likely return if it became a net exporter again.
According to its statutes, one of the principal goals is the determination of the best means
for safeguarding the organization's interests, individually and collectively. It also pursues ways
and means of ensuring the stabilization of prices in international oil markets with a view to
eliminating harmful and unnecessary fluctuations; giving due regard at all times to the interests
of the producing nations and to the necessity of securing a steady income to the producing
countries; an efficient and regular supply of petroleum to consuming nations, and a fair return on
their capital to those investing in the petroleum industry.
OPEC's influence on the market has been widely criticized, since it became effective in
determining production and prices. Arab members of OPEC alarmed the developed world when
they used the ―oil weapon‖ during the Yom Kippur War by implementing oil embargoes and
initiating the 1973 oil crisis. Although largely political explanations for the timing and extent of
the OPEC price increases are also valid, from OPEC’s point of view, these changes were

triggered largely by previous unilateral changes in the world financial system and the ensuing
period of high inflation in both the developed and developing world. This explanation
encompasses OPEC actions both before and after the outbreak of hostilities in October 1973, and
concludes that ―OPEC countries were only 'staying even' by dramatically raising the dollar price
of oil.
OPEC's ability to control the price of oil has diminished somewhat since then, due to the
subsequent discovery and development of large oil reserves in Alaska, the North Sea, Canada,
the Gulf of Mexico, the opening up of Russia, and market modernization. As of November 2010,
OPEC members collectively hold 79% of world crude oil reserves and 44% of the world’s crude
oil production, affording them considerable control over the global market.[6]The next largest
group of producers, members of the OECD and the Post-Soviet states produced only 23.8% and
14.8%, respectively, of the world's total oil production.[7] As early as 2003, concerns that OPEC
members had little excess pumping capacity sparked speculation that their influence on crude oil
prices would begin to slip.
Venezuela and Iran were the first countries to move towards the establishment of OPEC
in the 1960s by approaching Iraq, Kuwait and Saudi Arabia in 1949, suggesting that they
exchange views and explore avenues for regular and closer communication among petroleum-
producing nations.[citation needed] The founding members are Iran, Iraq, Kuwait, Saudi Arabia, and
Venezuela. Later members include Algeria, Ecuador, Gabon, Indonesia, Libya, Qatar, Nigeria,
and the United Arab Emirates.
In 10–14 September 1960, at the initiative of the Venezuelan Energy and Mines minister Juan
Pablo Pérez Alfonzo and the Saudi Arabian Energy and Mines minister Abdullah al-Tariki, the
governments of Iraq, Iran, Kuwait, Saudi Arabia and Venezuela met in Baghdad to discuss ways
to increase the price of the crude oil produced by their respective countries.
Oil exports imports difference
OPEC was founded to unify and coordinate members' petroleum policies. Original OPEC
members include Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. Between 1960 and 1975, the
organization expanded to include Qatar(1961), Indonesia (1962), Libya (1962), the United Arab
Emirates (1967), Algeria (1969), and Nigeria (1971).Ecuador and Gabon were early members of
OPEC, but Ecuador withdrew on December 31, 1992[10] because it was unwilling or unable to
pay a $2 million membership fee and felt that it needed to produce more oil than it was allowed
to under the OPEC quota,[11] although it rejoined in October 2007. Similar concerns prompted
Gabon to suspend membership in January 1995.[12]Angola joined on the first day of 2007.
Norway and Russia have attended OPEC meetings as observers. Indicating that OPEC is not
averse to further expansion, Mohammed Barkindo, OPEC's Secretary General, recently asked
Sudan to join.[13] Iraq remains a member of OPEC, but Iraqi production has not been a part of
any OPEC quota agreements since March 1998.
In May 2008, Indonesia announced that it would leave OPEC when its membership
expired at the end of that year, having become a net importer of oil and being unable to meet

its production quota.[14]A statement released by OPEC on 10 September 2008 confirmed
Indonesia's withdrawal, noting that it "regretfully accepted the wish of Indonesia to suspend its
full Membership in the Organization and recorded its hope that the Country would be in a
position to rejoin the Organization in the not too distant future." [15] Indonesia is still exporting
light, sweet crude oil and importing heavier, more sour crude oil to take advantage of price
differentials (import is greater than export) due to Air pollution in Indonesia still being low as
compared to China or India.
1973 oil embargo
The 1973 oil embargo happened in October following the United States' and Western
Europe's support of Israel against Arab nations in the Yom Kippur War of 1973. Iran being chief
among those angered by western support of Israel. As a nation Iran stopped providing oil to the
United States and Western Europe. In doing so, the oil pricing for the United States went from 3
dollars a barrel to 12 dollars a barrel, spurring gas rationing. U.S. stations put a limit both on the
amount of gas that could be dispensed, closed on Sundays, and limited the days it could be
purchased based on licence plates. For example if the last digit on a car's license plate was even
gas could only be purchased on even days.[citation needed] Prices continued to rise after the Embargo
ended. [16] The Oil Embargo of 1973 had a lasting effect on the United States. U.S. citizens began
purchasing smaller cars that were more fuel efficient. The embargo also forced America to
reevaluate the cost and source of energy which previously receive little consideration. The
Federal government got involved first with President Nixion recommending citizens reduce their
speed for the sake of conservation, and later Congress issuing a 55mph limit at the end of 1973.
This changed decreased consumption as well as crash fatalities. Daylight savings time was
extended year round to reduce electrical use in the American home. Nixon also formed the
Energy Department as a cabinet office. People were asked to decrease their thermostats to 65
degrees and factories changed their main energy supply to coal.
One of the most lasting effects of the Oil Embargo of 1973 was an economic recession
throughout the world. Unemployment flew to the highest percentage on record while inflation
did the same. In Detroit, consumer interest in large gas guzzling vehicles fell and production
dropped. Although the embargo only lasted one year, oil prices had quadrupled and a new era of
international relations was opened. Arab nations discovered that their oil could be used as both a
political and economic weapon against other nations.
1975 hostage incident
On 21 December 1975 Ahmed Zaki Yamani and the other oil ministers of the members
of OPEC were taken hostage by a six-person team led by terrorist Carlos the Jackal (which
included Gabriele Kröcher-Tiedemann and Hans-Joachim Klein), in Vienna, Austria, where the
ministers were attending a meeting at the OPEC headquarters. Carlos planned to take over the
conference by force and kidnap all eleven oil ministers in attendance and hold them for ransom,
with the exception of Ahmed Zaki Yamani and Iran's Jamshid Amuzegar, who were to be
executed. Carlos led his six-person team past two police officers in the building's lobby and up to

the first floor, where a police officer, an Iraqi plain clothes security guard and a young Libyan
economist were shot dead.
As Carlos entered the conference room and fired shots in the ceiling, the delegates
ducked under the table. The terrorists searched for Ahmed Zaki Yamani and then divided the
sixty-three hostages into groups. Delegates of friendly countries were moved toward the door,
'neutrals' were placed in the centre of the room and the 'enemies' were placed along the back
wall, next to a stack of explosives. This last group included those from Saudi Arabia, Iran, Qatar
and the UAE. Carlos demanded a bus to be provided to take his group and the hostages to the
airport, where a DC-9 airplane and crew would be waiting. In the meantime, Carlos briefed
Ahmed Zaki Yamani on his plan to eventually fly to Aden, where Yamani and the Iranian
minister would be killed.
The bus was provided the following morning at 6.40 as requested and 42 hostages were boarded
and taken to the airport. The group was airborne just after 9.00 and explosives placed under
Yamani's seat. The plane first stopped in Algiers, where Carlos left the plane to meet with the
Algierian Foreign minister. All 30 non-Arab hostages were released, excluding Amuzegar.
The refueled plane left for Tripoli where there was trouble in acquiring another plane as had been
planned. Carlos decided to instead return to Algiers and change to a Boeing 707, a plane large
enough to fly to Baghdad nonstop. Ten more hostages were released before leaving.
With only 10 hostages remaining, the Boeing 707 left for Algiers and arrived at 3.40 a.m. After
leaving the plane to meet with the Algerians, Carlos talked with his colleagues in the front cabin
of the plane and then told Yamani and Amouzegar that they would be released at mid-day.
Carlos was then called from the plane a second time and returned after two hours.
At this second meeting it is believed that Carlos held a phone conversation with Algerian
President Houari Boumédienne who informed Carlos that the oil ministers' deaths would result in
an attack on the plane. Yamani's biography suggests that the Algerians had used a covert
listening device on the front of the aircraft to overhear the earlier conversation between the
terrorists, and found that Carlos had in fact still planned to murder the two oil ministers.
Boumédienne must also have offered Carlos asylum at this time and possibly financial
compensation for failing to complete his assignment.
On returning to the plane Carlos stood before Yamani and Amuzegar and expressed his regret at
not being able to murder them. He then told the hostages that he and his comrades would leave
the plane after which they would all be free. After waiting for the terrorists to leave, Yamani and
the other nine hostages followed and were taken to the airport by Algerian Foreign
Minister Abdelaziz Bouteflika. The terrorists were present in the next lounge and Khalid, the
Palestinian, asked to speak to Yamani. As his hand reached for his coat, Khalid was surrounded
by guards and a gun was found concealed in a holster.
Some time after the attack it was revealed by Carlos' accomplices that the operation was
commanded by Wadi Haddad, a Palestinian terrorist and founder of the Popular Front for the
Liberation of Palestine. It was also claimed that the idea and funding came from an Arab
president, widely thought to be Muammar al-Gaddafi.

In the years following the OPEC raid, Bassam Abu Sharif and Klein claimed that Carlos had
received a large sum of money in exchange for the safe release of the Arab hostages and had kept
it for his personal use. There is still some uncertainty regarding the amount that changed hands
but it is believed to be between US$20 million and US$50 million. The source of the money is
also uncertain, but, according to Klein, it was from "an Arab president." Carlos later told his
lawyers that the money was paid by the Saudis on behalf of the Iranians and was, "diverted en
route and lost by the Revolution".
After 1980, oil prices began a six-year decline that culminated with a 46 percent price drop in
1986. This was due to reduced demand and over-production that produced a glut on the world
market. Around this period, Iraq also increased its oil production to help pay for the Iran-Iraq
War. Overall OPEC lost its unity and thus its net oil export revenues fell in the 1980s.
Responding to war and low prices
Leading up to the 1990-91 Gulf War, Iraqi President Saddam Hussein advocated that
OPEC push world oil prices up, thereby helping Iraq, and other member states, service debts. But
the division of OPEC countries occasioned by the Iraq-Iran War and the Iraqi invasion of
Kuwait marked a low point in the cohesion of OPEC. Once supply disruption fears that
accompanied these conflicts dissipated, oil prices began to slide dramatically.
After oil prices slumped at around $15 a barrel in the late 1990s, concerted diplomacy,
sometimes attributed to Venezuela’s president Hugo Chávez, achieved a coordinated scaling
back of oil production beginning in 1998. In 2000, Chávez hosted the first summit of heads of
state of OPEC in 25 years. The next year, however, the September 11, 2001 attacks against the
United States, the following invasion of Afghanistan, and 2003 invasion of Iraq and subsequent
occupation prompted a surge in oil prices to levels far higher than those targeted by OPEC
during the preceding period. Indonesia withdrew from OPEC to protect its oil supply interests.
On November 19, 2007, global oil prices reacted strongly as OPEC members spoke openly about
potentially converting their cash reserves to the euro and away from the US dollar.[20]
Production disputes
The economic needs of the OPEC member states often affects the internal politics behind OPEC
production quotas. Various members have pushed for reductions in production quotas to increase
the price of oil and thus their own revenues.[21] These demands conflict with Saudi Arabia's
stated long-term strategy of being a partner with the world's economic powers to ensure a steady
flow of oil that would support economic expansion.[22] Part of the basis for this policy is the
Saudi concern that expensive oil or oil of uncertain supply will drive developed nations to
conserve and develop alternative fuels. To this point, former Saudi Oil Minister Sheikh Yamani
famously said in 1973: "The stone age didn't end because we ran out of stones."
One such production dispute occurred on September 10, 2008, when the Saudis
reportedly walked out of OPEC negotiating session where the organization voted to reduce
production. Although Saudi Arabian OPEC delegates officially endorsed the new quotas, they
stated anonymously that they would not observe them. The New York Times quoted one such

anonymous OPEC delegate as saying ―Saudi Arabia will meet the market’s demand. We will see
what the market requires and we will not leave a customer without oil. The policy has not
changed.‖