This document summarizes key concepts relating to international trade and monetary systems. It discusses Adam Smith's theory of absolute advantage, showing how countries can benefit from specializing in goods they have a cost advantage in producing. It then discusses Ricardo's theory of comparative advantage, noting trade can occur even if one country has an absolute advantage in all goods. The document also summarizes the gold standard system, its breakdown during WWI, and the establishment of the IMF to help restore order and facilitate international trade and payments. It describes how the IMF uses tools like SDRs and country quotas to achieve its goals.

1. Gains from Trade

2. Adam Smiths
Theory of Absolute Advantage

Country should specialize in the production of commodities
which it can produce most efficiently – Lower Cost of Production.

A country tends to specialize in production of commodities in which
it has Absolute Advantage
Per Quintal Labour Cost (Man- hour)
Country
Rice
Jute
India
30
60
Bangladesh
50
20

3. Adam Smiths
Theory of Absolute Advantage
Would should country’s be doing?

India




India should specialise in Rice production.
As India has to sacrifice 2 Qtl of Rice for 1 Qtl of Jute.
It can import jute from Bangladesh
1Qtl of Rice = 1.5 Qtl of Jute (30/20)
Bangladesh
 Should specialise in Jute
 Import Rice from India
 As in domestic trade they get 0.4 Qtl of Rice (20/50) for Jute
 If they trade they get 0.67 Qtl of Rice (20/30) for 1 Qtl of jute.

4. Ricardo's Insight

What if one country has absolute advantage in both the
commodities?

Is trade possible?

As long as countries have comparative advantage in the production
of both the commodities specialisation and trade would always be
possible.
Per Quintal Labour Cost (Man- hour)
Country
Rice
Jute
India
30
60
Bangladesh
50
80

5. Ricardo's Insight

India
It can produce both the goods efficiently.
It has comparative advantage in rice production.
It can produce Rice at 60% (30/50) cost then Bangladesh.
It has comparative disadvantage in jute because cost of jute
production is twice the cost of rice production.

Bangladesh
It has comparative advantage in jute production
Relative cost of jute production ( 80/50 = 1.6 Qtl of rice) is
less than India’s(60/30= 2Qtl of rice).

6. Gains from Foreign Trade
Internal Exchange Rate (Quintal)
Bangladesh
India
Rice
Jute
Rice
Jute
1
0.5
1
0.625
50/80
30/60
2
1
1.6
1

7. Who Gains from Trade?
Who Gains India or Bangladesh?




It depends upon the determination of commodity exchange rate
between two countries.
India’s exchange rate ranges between 500Kg to 625 kg of Jute
for 1 Qtl of Rice.
Bangladesh it ranges between 1.6 to 2 Qtl of Rice for 1 Qtl of
Jute.
If Exchange rate in foreign trade are same as internal rates then
both the country gain.

8. Heckscher-Ohlin Theory of Trade

The comparative advantage in the cost of production is due to the difference
s in the factor endowment of the nations.

It refers to the overall availability of usable resources in the country.
A country tends to specialise in the export of a commodity whose
production requires intensive use of its abundant resources and
imports a commodity whose production requires intensive use of its
scarce resources.

9. International Monetary
System

10. The Gold Standard

The earliest form of International Monetary system


In use for 4 decades before the onset of World War I
The principles



Domestic currency system (coins or paper) – fully repayable in
Gold
Gold could be freely imported or exported in unlimited quantities
between countries
The exchange rates were fixed on the basis of their gold parity at
fixed par values

11. The Gold Standard

The mechanism




The flow of Gold from trade deficit countries to trade surplus
Gold losing countries experienced reduction in money supply, money income
& fall in prices
Gold receiving countries experienced increase in money supplies, income &
prices
These conditions made goods & services flow from trade deficit countries to
surplus ones.
Thus gold standard system automatically restored equilibrium

12. The Gold Standard

The breakdown





World War I rudely shattered the economic order
Because of hyper Inflation – gold payments were suspended
Consequently convertibility of currencies broke down
It was expected that freely fluctuating exchange rates would restore
competitive price and cost system which would automatically restore stability
However, it stimulated speculation in hot currencies





Over valuation of Pound Sterling
Undervaluation of French & Belgium Francs
Collapse of German Mark
Due to war – free trade & flexible exchange rate gave way to restrictions &
exchange control
And the world went into complete disarray leading to
collapse of the gold standard

13. What Happened Next…

Restoration attempts were not very successful.
 And in 1931 with Britain going off gold standard – it finally collapsed

Emergence of currency blocs
 Formal & Informal arrangements between members
 4 prominent blocs
 Sterling area, French Bloc, COMECON (Soviet Bloc), Dollar area
 It was a chaotic monetary system
 With multiple exchange rates
 Exchange rate fluctuations were frequent
 Import restrictions & exchange controls were widespread
 Competitive devaluation had become order of the day.
 All this lead to serious economic erosion of super powers – USA, UK,
& France

The order was finally restored with establishment of IMF.

14. International Monetary Fund

IMF – came into existence in 1945 & started functioning in 1947
 Started with 7 members and had 180 members in 2000.

It combined the characteristics of both
 Gold standard;


Fluctuating exchange rate


Gold remained the universally accepted medium payment.
Dollar & Pound Sterling emerged as reserve currencies supplementing Gold
as internationally acceptable assets.
Exchange rates were fixed in Gold and also linked to Dollar or Pound
 With fixation of exchange rates – convertibility of currencies was
restored.

15. International Monetary Fund
IMF also restored multilateral payment system with following
conditions.

No country is supposed to impose new exchange controls without IMF’s
approval.

To ensure flexibility in exchange rates within prescribed limits – the
members were not permitted to vary spot exchange rates more
than 1 % beyond upper & lower limits.


To deal with short run payment difficulties a member will be allowed to
borrow 25% of the quota in a year – though total borrowing can be
125% of the quota across 5 years.
To overcome fundamental disequilibrium – IMF may permit devaluation of
currency by 10%. Beyond that only through negotiations

16. International Monetary Fund
With the establishment of IMF:


Within 5 years multilateral payment system was fully restored
By 1958 most major currencies had become convertible, restrictions
on payment had disappeared and a free payment system was
universally established

17. International Monetary Fund

Purpose of IMF
 To promote international monetary cooperation

To facilitate expansion and balanced growth of international trade

To maintain exchange rate stability

To assist members in establishment of multilateral system of
payments and elimination of foreign exchange restrictions

To give confidence to members by making fund’s resources available
to them to correct balance of payments

To shorten the duration and lessen the degree of disequilibrium in the
international balance of payments of members

18. Collapse of IMF System

In 1960s – there was serious inadequacy of international liquidity

Shortage of gold & foreign exchange reserves to remove in
deficit in BOP because world trade was growing faster than world
reserves

For instance during 1950-71 world trade grew at 8 % per annum
– where as Reserve increased by 2-3% per annum during this
period

The smaller stock of gold and fixed exchange rate system created
instability.

Led to severe BOP Deficit in USA

19. Special Drawing Rights

This necessitated the search for a new kind of reserve asset to
supplement gold stock & create additional international liquidity
SDR

20. Special Drawing Rights

SDR – is a kind of ‘reserve asset’ – created through amendment
of IMF system.

It is nick-named ‘paper gold’ – since it performs the functions of
gold in international payment system

It is not




A paper currency
Nor a coin
Nor a credit note
Nor a treasury bill

SDRs are simply entries in SDR-account of participating countries.

Though SDRs figure in the published reserves of a nation.

21. Special Drawing Rights

SDRs serve as ‘means of payment’ between the participating
nations for the purpose of legitimate purchase of foreign exchanges
and for making up for the deficit in balance of payment.

In SDR transactions participating nations are not required to transfer
their currency or any other asset against SDRs received in allocation.

They are simply credited to the participants’ accounts and are then
available for use.

SDRs are defined in terms of a basket of major currencies used in
international trade and finance. The amounts of each currency making
up one SDR are chosen in accordance with the relative importance of
the currency in international trade and finance

22. Special Drawing Rights

3 ways to transact in SDRs
 Receive foreign exchange from a participant designated by the fund
 Through mutual agreements between the participants to redeem their
own currency held by another nation
 For transaction with the Fund’s General Account.

SDR Quota



Quota subscriptions generate most of the IMF's financial resources.
Each member country of the IMF is assigned a quota, based broadly
on its relative size in the world economy.
A member's quota determines its maximum financial commitment to
the IMF and its voting power, and has a bearing on its access to IMF
financing. Total quotas at end-March 2008 were SDR 217.3 billion
(about $357.3 billion).

23. Special Drawing Rights
What are the functions of quotas?

Subscriptions.
A member's quota subscription determines the maximum amount of financial
resources the member is obliged to provide to the IMF.
A member must pay its subscription in full upon joining the Fund: up to
25 percent must be paid in SDRs or widely accepted currencies (such as the
U.S. dollar, the euro, the yen, or the pound sterling), while the rest is paid in the
member's own currency.

Access to financing.
The amount of financing a member can obtain from the IMF (its access limit) is
based on its quota, a member can borrow up to 100 percent of its quota annually
and 300 percent cumulatively.

24. Composition of SDR
• The largest member of the IMF is the United States, with a quota of
SDR 37.1 billion (about $61.0 billion),
• The smallest member is Palau, with a quota of SDR 3.1 million
(about $5.1 million).

25. The Present IMF System

The present IMF is on MANAGED FLOATING SYSYTEM

It allows member nations the choice of foreign exchange as long as it
does not injure the interest of their trade partners.

Most of the nations pegged their currencies to the US Dollar, SDR and
basket of currencies.

26. Trade Agreements

27. Need for Trade Agreements

Helps in overcoming trade barriers

Promotes trade amongst member countries

Increases efficiency – through economies of scale (spreading fixed
cost over larger regional markets)

Increased economic growth from foreign direct investment

Promotes regional infant industries through protected regional
market

Increased security of market access for smaller countries.

Improves members bargaining strength in multilateral trade
negotiations.

Strengthens political ties and managing migration flows.

28. Trade Agreements
Trade Agreements
Bi-lateral
Regional
Multi-lateral

29. Trade Agreements

Bi-Lateral Agreement
Trade agreements between two countries.

Regional Trade Agreements (RTAs) :
Trade agreements between group of countries – may or may not
belong to same geographical region

Multi-lateral Agreements
Trade agreements between multiple countries – GATT/WTO

30. Multilateral Trade

GATT ( General Agreement of Trade and Tariff)

Formed in 1948 to liberalize Trade.

Till 1994 this was the forum for negotiating lower customs duty
rates and reducing other trade barriers.

Provided a framework for trade expansion vis-à-vis removing
barriers on free movement of goods and services.

‘Rounds’ the West, negotiated trade deals with themselves in
mind.

The developing world were forgotten as backward and without
any clout.

31. GATT v/s WTO
GATT
WTO
It is Adhoc and provisional.
Its agreement are permanent.
It had contracting parties.
It has members.
It allowed existing domestic
legislation to continue even if it
violated the agreement.
WTO does not permit it.
It was less powerful, dispute
system settlement system was
slow and less efficient and its
ruling could be blocked.
WTO is more powerful,
mechanism faster and more
efficient and difficult to block the
rulings.

32. WTO IMPACT
GATT / GATS
TRIMS
TRIPS
Liberalisation of trade
in
goods and services
Liberalisation of
international
investment
Provides monopoly
power to owners
of intellectual

33. Multilateral Trade

The WTO (World Trade Organisation) is an international organization
dealing with the rules of trade between countries.

The WTO can be said to be made up of different entities:

Laws governing international commerce and are contracts by which
governments agree to trade policies that would be beneficial to all the
WTO member nations.

Countries can negotiate these agreements, settle disputes arising from
the agreements and help other countries join the negotiations .

WTO is GATT plus – GATS (General agreement on trade in services)
and TRIPS (Trade related intellectual property rights).

Helping countries, especially developing countries, develop and review
national trade policies.

34. Regional Trade
Agreements

35. RTA focus – not only true for India but it
is a global reality
300
2007

36. Types of RTA’s

37.  Preferential Trade Agreement:
 A grouping of countries where partial preference to trading
partners are given.
Central American Common Market (CACM)

Free Trade Area:
 A grouping of countries to bring free trade between them.
 North American Free Trade Area (NAFTA)
 ASEAN Free Trade Area (AFTA)
 EFTA ( European Free Trade Association)
 LAFTA ( Latin america Free trade association)

Custom Union:
 Eliminates all restrictions on Trade members but also adopts a
uniform commercial policy against the non-member.
 European Economic Community (EEC)

38. 
Common Market:
 It allows free movement of labour and capital in addition to
having free movements of goods and having common
commercial policy for non-members.
 ECM ( European Common Market)
 CACM ( Central American Common Market)

Economic Union:
 Members countries have same economic policies, including
monetary and fiscal policy.
 EU ( European Union)

39. “What should be India’s focus –
bilateral/ regional or
multilateral trade agreement?”

40. Multilateral Trade

Overwhelming dominance of developed countries in the WTO.

The developing countries have not gained any meaningful increase
in market access in the key areas where they have comparative
advantage (textiles and agriculture).

Liberalization of services or trade has occurred only in sectors which
are of primary interest to developed countries like IT, ITES,
automobile and some manufactured goods.

Declining industrial tariff and removal of all quantitative restrictions
has the potential to harm the industrial sector of developing
countries.

Free trade is more suitable to the advanced countries which have
already established their industrial base.

41. Bilateral/ Regional Trade

Help the developing countries to expand market access without
compromising on national policies and interests

Lead to lower dependence on developed country markets and help
in resisting the pressures of economic superpowers

Helps to forge and foster stronger alliances at the multilateral trade
negotiations.

Allows infant industry protection

42. Thus, India is :

Focussing on BLT/RTAs first. So that it can balance differences and
build capabilities at par with developed countries and then move
towards a multilateral trade regime.

Some of the recent alignments
 Free trade area (FTA) agreements with Sri Lanka and Thailand
 Advance stages of free trade area agreement with Singapore
 Signed a framework agreement for a free trade area with the
members of the Association of South East Asian Nations
(ASEAN)
 An agreement to create a South Asian Free Trade Area
(SAFTA).
 Approached distant trading partners such as South Africa and
Brazil