1

Trade Restrictions:
1. Tariffs 2. Non-tariff
1. Tariffs:
- Tax or duty on import or export
- Ad valorem tariff is expressed as a % of the value of the traded commodity
- Specific tariff is a fixed sum per unit
- Compound tariff is a combination of ad valorem and specific tariff
- Due to tariff, domestic price of imported commodity rises by the full amount
of the tariff, domestic consumption decreases, domestic production increases,
import declines and government revenue increases.
- income redistributed from domestic consumers (who pay higher price for the
commodity) to domestic producers (who receive a higher price).
Px ($)
Sx
4
E
3
2

SF + T
T
SF
Dx

1
10

20

50

70

- With free trade, Px = $1, Nation 2 consume 70X of which 10X is produced
domestically and 60X imported.
- With 100% tax, Px is now $2, so Nation 2 consumes 50X, of which 20X
produced domestically and 30X imported.

Px ($)
4
3
2

SF + T

REDUCTION IN CONS SURPLUS

SF
Dx
x
50

70

- Reduction in CS = $60
Px ($)
Sx
4

Increase in
Producer Surplus

3
2

SF + T
T
SF

X
10

20

- Increase in PS is $15

Trade protection via Import Tax leads to inefficiency:

Px ($)
Sx
4
E

DWL = $5
DWL = $10

3
2

SF + T
T
SF
Dx

Tax Revenue
1
10

20

50

70

Reduction in CS = $60, increase in PS = $15

Increase in Government Rev = $30
So the Deadweight loss = $60 $15 $30 = $15
But why it is imposed? To protect domestic producers

Measuring the Degree of protection:

- Nation normally imposes lower (or zero) tariff on the importation of inputs
than on the importation of final products produced with the imported inputs in
order to encourage domestic production and employment.
- Example: Import Duty on car components < import duty on (fully assembled)
cars
- The rate of Effective Protection :
g = t ai t i
1 ai
where
g = the rate of effective protection to producers of final commodity
t = the nominal tariff rate on consumers of the final commodity
ai = the ratio of the cost of the imported input to the price of the final
commodity in the absence of tariff.

ti = the nominal tariff rate on the imported input

Example:
- In the production of suit, the domestic factory uses $80 of imported wool.
- The free trade price of the suit is $100, but the nation imposes 10% tariff on
imported suit, thus the domestic price is $110.
- So of the total $110, $80 represents imported wool, $20 is domestic value
added and $10 is the tariff.
- The $10 tax represents a 10% nominal tariff because nominal tariff is
calculated on the price of the final commodity ($10/$100).
- But the same $10 actually represents 50 % effective tariff rate because the
effective tariff rate is calculated based on the domestic value added (for
producing suit) i.e. $10/$20 = 50 %
- Based on this example, t = 10% or 0.1, ai = $80/$100 = 0.8, and ti = 0
So g = 0.1 (0.8)(0) = 0.1 0 = 0.5 = 50%
1 0.8
0.2
- If 5% nominal tariff is imposed on the imported input (ti = 0.05), then
g = 0.1-(0.8)(0.05) = 0.1 0.04 = 0.06 = 0.3 = 30%
1- 0.8
0.2
0.2
Note :
Effective Rate of protection
- Note: `The two rates are equal (g = t) when there is no imported inputs (ai = 0
or 100% domestic value added). In other words, Effective tariff is equal to
nominal tariff if production is based totally on domestic resources
because the tariff on intermediate goods is nonexistent or irrelevant.
- For given value of ai and ti , g is larger the greater the value of t (meaning:
higher nominal tariff on final products implies higher protection for
domestic producers)
- For given value of t and ti g is larger the greater is the value of ai (meaning:
the larger the portion of imported inputs, the more benefit of protection the
domestic producer can feel or enjoy.
- When aiti is larger than t, the rate of Effective protection is negative
(meaning: very high import tax on imported inputs or very low nominal
tax on imported final products is very disastrous to the local producers)
- g is normally higher than t in the industrial nations.

Non-tariff Barriers
1) Import quota
- most important nontariff trade barrier
- It is a direct quantitative restriction on the amount of a commodity allowed to
be imported or exported.
- Of two types:
- 1) absolute quota - specified within a period and based on first come first
served, and normally it's set world wide. Example: USA restrict imports of
sugar, textile product.
- 2) tariff rates quota - Allowing import of goods at a specified quantity at a
reduced tariff rates during a specified quota period; Example: tuna, olives
import to USA.
- Exporting Nations need to apply the quota prior to export.
- The impact on consumption and production is quite similar to the import tariff
Comparison of Import Quota and Tariff
- with import quota, increase in demand will result in a higher domestic price
and greater domestic production as compared to an equivalent import tariff.
- With a given import tariff, increase in demand will leave the domestic price
and domestic production unchanged, but result in a higher consumption and
imports than with an equivalent import quota.
Px
Sx

3
2.5
2
1

E
J
J
C

H
H
N

K
B
Dx

Dx
X

20

50 55

- With free trade, Px = $1, an import quota of 30X (JH), results Px = $2, cons of
50X of which 20X is produced domestically.
- If import license is auctioned to the highest bidder, then revenue effect would
be $30 (JHNM), same as 100% import tariff.
- With increase in demand from Dx to Dx, cons rises from 50X to 55X, of
which 25X is domestically produced.
Other non-tariff trade Barriers
2) Voluntary Export Restraint
- The importing nation induces or persuades the exporting nations to curb its
exports of a commodity voluntarily
- Practised by USA, EU to reduce imports of textiles, steel, electronic products
etc from Japan since 1950
- In May 1981, Japanese agreed to reduce export of car to USA, max of 1.85
millions, 1.85 mill in 1984 and 2.3 mill 1985.
- VER caused prices of Japanese and domestic cars increased in USA
3) Technical, administrative and other Regulations:
- Used to hamper exporters
- Includes environmental issues (banning of tropical forest logging to protect
non-tropical timber price), safety, health, packaging, labuyng and so many
other regulations
The case of Gasoline import regulation by EPA:
- In Dec. 1993, EPA instituted import standards for both reformulated and
conventional gasoline in order to control emissions.
- This EPA regulation is effectively less favorable to foreign refiners as
compared to domestic refiners
- In March, 1995, Venezuela filed complained to WTO against EPA regulation
and WTO ruled in favor of Venezuela
USA Meat import regulations:
- To be eligible to export meat to USA, a country must have had no outbreaks
of any animal diseases such as cattle mouth and foot diseases and must have
outlawed the vaccination for such diseases for one year.
- Exporters must certification from veterinary unit followed by US food safety
Inspection services with the cost borne by the exporting company

4) International Cartel
- Suppliers from different countries get together to restrict volume of output and
export
- Example OPEC, caused to petroleum price to increase sharply (quadruple)
1973-74.
- Can fail if members cheat on prices and quantity set, i.e. members export
larger volume that the specified ones and or sell at a lower price
- Domestic cartel is illegal in USA and Europe, but international cartel is hard
to control.
5) Dumping
- Export of a commodity at below cost or selling at a lower price abroad than
locally).
a) Persistent dumping
- international price discrimination to max profits
- firms with market power use price discrimination between markets to increase
their total profits.
- A firm will maximize profits by charging a lower price to foreign buyers if it
has greater monopoly power ( less competition) in its home market than
abroad and if buyers in the home country cannot avoid the high home prices
by buying the good abroad and importing it cheaply.
b) Predatory dumping
- temporary sale at the lower price abroad in order to drive foreign producers
out of business.
- The price set due to predatory dumping was so low that domestic competitors
could not cover variable costs at any level of production and would choose to
leave market.
- Once the rivals are gone, the firm will use its monopoly power to raise prices
and earn high profits.
c) Sporadic dumping or Cyclical dumping
- occasional sale at below cost or lower price abroad to reduce domestic
surplus.

- It is related to fluctuations in economic activities, whereby it occurs during

periods of recession.
- During the part of the business cycle when demand is low, a firm makes
export sales that are lower than its average costs. If these low prices gain
export sales, then the firm can use more of its production capacity and provide
work for its labor.
d) Seasonal dumping
- is intended to sell off excess inventories of a product, often without lowering
the price in the main market.
- For instance, toward the end of a fashion season, US clothing companies may
decide to sell off remaining stock of swimsuits at very low prices in Canada
- Prices in the major US market are kept more stable, with the Canadian market
absorbing the extra supply.
Trigger price mechanism
Nations impose high import duty on dumped commodity to increase the price.
Examples of Dumping cases:
1) Sony
- the US government charged SONY of Japan for dumping their product in the
US market in 1970
- Investigation showed that SONY was selling TV sets made in Japan for $180
while charging Japanese consumers $333 for the same model.
2) Cement
- In August 1990, the US Department of Commerce ruled that cement suppliers
in Mexico were dumping their product in the US market.
- Antidumping duties were then imposed to the suppliers from Mexico. The
duties were 57.96 per cent on products of Cemex S.A. Mexicos largest
cement producer, 53.26 per cent for Apasco S.A.de C. V.; and 57.65 per cent
for all other Mexican suppliers.
3) DRAM
- In June, 1999, The U.S. Commerce Department planned to impose a 13.11%
DRAM tariff against Hyundai Electronics Industries Co. and a 10.67% penalty
against LG Semicon Co. for dumping during the 12 months ended April 30, 1998.

10

6) Export subsidies
- direct payments or tax relief or subsidized loans to the nations exporters and
low-interest loans to foreign buyers to stimulate nations exports.
- Example: Under the 1985 Agricultural Export enhancing program (EEP), US
exporters are paid subsidies when can export to certain countries where US
sales has been nonexistent, displaced, reduced or threatened
- Budget for EEP was US$350 mill in 1996, US$500 mill in 1998, US$550 mill
in 1999.
- Products included under EEP: Wheat, semolina, barley, vegetable oil, etc.
Example of Export subsidy (PALM OIL):
20th March 2001
- Malaysia extend 10 million dollars in credit to Cuba to purchase its palmoil
- provide the credit facility to a Cuban company, Empresa Cubana Importadora
de Alimentos,
- This is under the palm oil credit payment arrangement (POCPA) arrangement,
whereby the Cuban firm will provide products to selected Malaysian
companies to be sold in Malaysia or other countries in order to offset the
credit.
- nine countries -- Pakistan, Algeria, Iran, Iraq, Myanmar, Bosnia-Herzegovina,
Cuba, Sudan and Korea -- had signed POCPA agreements with Malaysia so
far.
- government's total allocation is 500 million dollars, and only 227.4 million
dollars have been used
- the scheme had proven effective in penetrating new and difficult markets.
- PO price plunged from a high of 2,377 ringgit (626 dollars) a tonne in 1998 to
around 800 ringgit.
Political economy of protectionism
- Fallacious Arguments:
1) to protect domestic labor against cheap foreign labor (fallacious
because nation can lower domestic labor cost by increasing
productivity or specialize in nonlabor intensive commodity and do
the trade).

11

2) scientific tariff to mato the price of imported commodity

equal to domestic price (fallacious because it will finally eliminate
international price difference and eliminate trade altogether.

- Questionable Arguments:
1) To reduce domestic unemployment
2) To cure trade deficit
Because these two measure can only be achieved at the cost of the neighbors.
- Qualified arguments:
1) Infant industry arguments, temporary protection to establish and protect
domestic industry during its infancy until it can compete with foreign
producers.
Most favoured nation principle:
- Any tariff reduction agreement signed with a (favorite) nation is extended to all
trade Partners
- Disadvantage: freeloader nation (not directly involved in negotiations and not
making any tariff concession of their own) also benefit.
-Example: If Msia cut down its import tax on product X (imported from its
favorite trade partner, Japan) from 50% to 25%, then any X imported from any
other country would also deserve that rate of tariff)
The General Agreement on Tariff and Trade or GATT (1947 in Geneva,
Switzerland)
- To promote trade through multilateral trade negotiations
- Based on 3 principles:
1) Nondiscrimination, based on most favored nation principle except for
the cases of economic integrations such as European Union (meaning
European member countries may reduce or eliminate tariff among
them without having to reduce or eliminate tariff for the same goods
imported from non-EU members.

12

2) Eliminations of nontariff trade barriers like quota except for agric

products and nations in BoP difficulties
3) Consultation among nations in solving trade disputes within GATT
framework.
- 124 nations were signatories during Uruguay Round 1993, excluding USSR
and China.
- Through GATT, 35% world tariff were reduced during 1947-1962 after 5 trade
negotiations.
Major provisions fo the Uruguay Round (took effect July 1, 1995)
- Tariff on industrial products be reduced from average of 4.7% to 3%, the share
of goods with zero tariff should be increase from 20-22% to 40-45%.
Removing tariff on pharmaceutical, construction equipment, medical
equipment, paper products and steel.
- Should replace quotas on agric and textile imports with less restrictive tariff
over 10 year period.
- Tougher antidumping measures
- Replacement of GATT secretariat with World Trade Organization (WTO).
Trade dispute can be settled by 2/3 or of the nations majority.
WTO
- The World Trade Organization was established in January, 1995 following the
Uruguay Round of General Agreement on Tariffs and Trade (GATT)
negotiations.
- By February 2002, it has 144 member states, (Moldova being the latest member)
accounting for over 90% of world trade.
- The WTOs overriding objective is to help trade flow smoothly, freely, fairly
and predictably. The goal is to improve the welfare of the peoples of the member.
- The WTO transformed the GATT (which focused primarily on tariff and quota
cuts), into a new global commerce agency with the same legal status as the
United Nations.
- Unlike GATT, WTO is empowered to enforce global commerce rules with the
imposition of economic sanction.

13

- The WTO's rules are also much broader, covering food and environmental
standards, regulation of services such as insurance and transport, how the
government can use tax dollars, copyright and patent law, farm policy, and more.
- The WTO expanded key aspects of the North American Free Trade Agreement
(NAFTA), which had been signed the year before, to the entire world.
- WTO rules subject a broad array of non-trade-related local and national
laws, regulatory structures, and policy approaches to challenge if they are
claimed to pose barriers to trade and investment.
- Within 4 years, there have been 117 cases in which a country has challenged a
law or practice of another country. Eighteen cases have led to binding WTO
rulings, and another 18 are currently being considered at the WTO tribunals.
- The WTO's tribunals conduct WTO challenge cases in secret. Even briefs
from the public are only accepted by WTO panels if endorsed by a
government. (NGOs cannot file briefs with the WTO unless a government is
willing to submit the briefs.)
- Only national governments are allowed to participate, so a state attorney general
could only assist with defense of a challenge against a state law if invited by the
current administration.
- A government that has lost a WTO case has no recourse to appeal outside of the
WTO's limited appellate process.
- Once a final WTO ruling is issued, losing countries have only three choices:
1) change their law to conform to the WTO requirements, 2) pay permanent
compensation to the winning country, or 3) face trade sanctions.
Example of WTO rulings:
- Related to import quota of sugar imposed by the USA, Under WTO rules, USA
must allow minimum of 1.256 million (Short Tones) of sugar annually
- Related to Venezuela complaints on EPA regulation on import of gasoline, in
January, 1996, WTO ruled that USA was in violation of article III, of GATT,
known as national treatment principle which requires equal treatment for imports
and domestic products.
Economic Integration: Custom Unions and Free Trade Areas
Stages of economic Integration:
1) Preferential trade arrangement 2) Free trade areas 3) Custom union 4)
common markets 5) economic union

14

1) Preferential trade arrangement

- Provide lower trade barriers among members as compared to nonmembers
- Example: British Commonwealth Preference Scheme (1932), British and excolonies
2) Free trade area
- all trade barriers are removed among members and each members retains its
own barriers to trade with nonmembers
- Example: 1) North American Free Trade Arrangement (NAFTA), formed by
USA, Canada and Mexico in 1993. 2) EFTA (UK, Austria, Denmark,
Norway, Portugal, Sweden, Switzerland, 1961) 3) AFTA
3) Custom Union
- No trade barriers among members and setting common tariff rates towards the
rest of the world
- Example: 1) European Union or European Common Market: West Germany,
France, Italy, Belgium, the Netherlands, and Luxembourg, 1957.
4) Common market
- Similar to custom union but in addition allowing movement of labor and
capital among member nations.
- Example: EU (achieved this status in 1993)
5) Economic Union
- like custom union but in addition the monetary and fiscal policies of member
states are harmonized. Having the same currency.
- Example: 1) USA 2) Benelux (Belgium, the Netherlands, Luxembourg)
3) European Union
Effects of forming custom unions:
Trade Creation
- Occurs when volume of trading increase as domestic production in a union
member is replaced by lower-cost imports from another member nation.
Specialization, overall production and welfare increase.

15

- It also increases the welfare of nonmembers as the increase in real income

spills over into increased imports from the rest of the world.
Px ($)

Nation 2
Sx

2
1

J
C

H
M

S1 +T
B

S1
X

10

20

50

70

- Before trade union, Px = $2, Nation 2 consumes 50X (30X imported from
nation 1). Nation 2 collect revenue of $30.
- As nation 2 and 1 form a custom union, nation 2 consumes 70X, (60X
imported from nation 1). Nation 2 does not import from nation 3 because in
nation 3 Px >$2.
- Nation 2 gains net $15 (JCM + HNB)
Trade Diversion
- Occurs when lower-cost imports from outside the custom union are replaced
by higher cost imports from a union member
- The preferential trade treatment has made importing from member country
cheaper
- It reduces welfare because it shifts production from more efficient (outside
union) to less efficient producers (within union)
- It worsen international allocation of resources and shifts production away
from comparative advantage.
Px ($)
Sx
Nation 2

16

E
2
1.5
1

J
J
M

S3 + T
H
H
N

S1 + T
S3
S1

B
Dx

10 15 20

50

60

70

- S1 and S3 are the perfectly elastic supply curve of X for nation 1 and nation 3
- Without union (whereby there is 100% nondiscriminatory tariff), Nation 2
imports 30X (JH) from nation 1 at Px = $2. Note: Without union price of X
from nation 3 is $3.
- As nation 2 and 3 form a union, importing X from nation 3 would be cheaper
(Px = $1.5)
- The welfare gain in nation 2 due to trade creation is $3.75 (JCJ + HHB).
- The welfare loss due to trade diversion is $15 (JMNH)
- So the net effect of this trade-diverting custom union is net welfare loss of
$11.25 for nation 2.
Trade Deflection (Effects of forming Free trade block)
- Trade deflection will occur if imports enter the FTA through the participating
country, which has the lowest tariff.
- assuming that transportation costs and other costs related to imports do not
outweigh the difference in tariff rates.
- the trade deflection effect will therefore limit the extent of trade diversion and
will have welfare-increasing effects in member countries.
- Trade deflection will reduce both the terms of trade gain for member countries
and the terms of trade loss for the outside world, ceteris paribus.

AFTA
-

The ASEAN Free Trade Area (AFTA) was initiated in 1993.

Reduce import tariffs on most products to 0-5 per cent by 2002
later implementation dates for Cambodia, Vietnam, Burma and Laos
AFTA covers various manufactured and agricultural products and considering
the constraint of each member, some flexibility is allowed in terms of
timetables for reducing tariffs and removing quantitative restrictions and other
non-tariff barriers.

17

- Four types of lists i.e. fast-track tariff cuts, temporary, sensitive and permanent
exclusions.

Prospects for the emerging industries

i)

ii)

iii)

Trade Creation: The formation of AFTA is expected to further boost intra-ASEAN. In

a way AFTA provide opportunities for the ASEAN companies to enjoy a bigger market of
510 million population and with the GNP capacity of US$820 billion.
Specialization: On the production side, AFTA creates a larger ASEAN's internal
market, which can deliver lower prices, attract investment and allow for specialisation of
production and economies of scale. More importantly, the reduction of high tariffs can
promote trade in intermediate products and encourage an international division of
labour in industrial production within ASEAN.
A more attractive place for FDI: Through AFTA, ASEAN can become more attractive to
MNCs. Indeed, FDI should remain an important backbone for a more competitive and
leading manufacturing activities and at the same time acting as a stimulant for the local
emerging industries.

Challenges of AFTA on the emerging industries

i)

Not ready to compete:

- There is sentiment of fear and worry that AFTA might cause distress to some
local industries. For example, Malaysia has asked for the postponement of
automobile industry into the inclusion list in order to protect her national
carmaker PROTON against competition from its own neighbor which has
become a regional arm for world leader of auto industry from Japan, Europe
and the USA.

ii)

Individual versus Collective Regional gain:

- Even within the current framework of AFTA, each nation seems to be taking
steps and measures that are more "individualistic" rather than "collaborative"
or "complementary" types of moves.

iii) Trade Deflection:

18

- non-collective planning and strategies among ASEAN members allows trade

deflection to take place
- For example, Thailand has been busy with Japan, Europe and the USA for
collaboration in automobile industries
- Singapore with Japan and New Zealand for various goods to be marketed in
the region approaching AFTA dateline.

How to Make AFTA successful and Beneficial to local ASEAN

industries?
Identify Every Nation's Strength and Advantages:
assigning the right duty based on each member's strength and weaknesses, and
understanding the spirit of common gain and not individual gain
- Nations endowed with more labor, land and raw resources like Indonesia
should concentrate on industries which are more labor intensive, resource
based, upstream and low skilled industries.
- On the other hand, Singapore which is relatively capital abundant as compared
to other ASEAN countries should engaged in industries which are capital and
technology intensive, high skilled and downstream production activities.
Formal Analysis:
AFTA, Trade Deflection, gates of entrance and Custom Union
- The good and bad of AFTA for the local emerging industries may be analyzed
using the following Figures (1, 2, and 3).
- Figure 1 shows a situation of pre-AFTA where each member imposes similar
barriers to ASEAN and Non-ASEAN countries.
- For simplicity, we only assume six nations (N1, N2, N3, N4, N5 and N6)
involved in the integration with their six new industries of specialization X1,
X2, X3, X4, X5 and X6 respectively.
- Before free trade area (FTA) is formed, each nation imposes relatively
higher barrier for products of their specialization, i.e. N1 imposes high tax
barrier on X1, N2 on X2 and so forth in order to protect their relatively infant
and emerging industries.

19

- When FTA is formed, as shown in Figure 2, trade barriers among members

are lifted (as indicated by the disappearance of bolded lines between member
countries) while barriers towards nonmembers are left NON-STANDARD
(up to each individual member to decide).
- Thus, each member will set barriers towards non-members such that their
welfare and benefits will be maximized.
- Unfortunately in doing so, they might or might not realize that members'
welfare would be affected by some of their trade policies towards the nonmembers.
- Specifically, they might totally remove tariff on products that are of the
specialization of the other member countries in the FTA.
- To the worse extent, a member might allow their countries to become a "gate
of entrance" for the products (that will put pressure on local products) from a
more advanced and established producers from outside the FTA.
- As shown in Figure 2, N1 produces X1 and at the same time welcomes
industry X2 from a more established world producer to operates in her
country.
- This will negatively affect the new and emerging industry X2 in nation N2.
- To complete the story, N2 which produces X2 also welcomes industry X3
from a more established world producer to operate in her land targeting for the
neighboring FTA markets and N2 action will negatively affect locally new
industry in N3.
- N3, N4, N5 and N6 are also involved in this unwise and non-strategic
business collaborations with the rest of the world as shown in Figure 2 and all
of them would as a matter of fact loose simultaneously.
- Most of the locally new or emerging industries would most likely be driven
out of the industries as they are not able to compete with the world
established and prominent producers.
- How to solve this problem?
- They must have a common policies towards the non-members.
- This can be achieved if they can transform AFTA into a more solid economic
integration i.e. a custom union which technically similar to free trade area but
on top of that set common policies and barriers towards the rest of the world
as illustrated in Figure 3.
- Members can collectively decide which industries or products should be
imported and restrict the entry of industries or products that can weaken the
local industries.

20

- It should be stressed that we are not promoting for permanent protection for
the emerging industries.
- The main purpose is to temporarily protect and strengthen the new industries
in the region and to come up with a more solid and strategic process of
economic integration.
- ASEAN economic integration through AFTA is quite unique because most of
the nations are still developing and new in various manufacturing industries.
- Without proper planning, they would not really benefit from the free trade
arrangement. When some of the members are positioning themselves as
"gates of entrance", bringing in products from other nonmember nations
and market them to their neighbors at merely zero tax barrier, then, on paper it
seems that intra-industry trade would increase but effectively more trade
actually takes place between ASEAN and NON-ASEAN countries, and more
dangerously, the local new and growing industries are being driven out"

21
FIGURE 1: PRE-AFTA

N1
X1
N6

N2

X6

X2

X5

X3

N5

N3
X4
N4

22
FIGURE 2: AFTA WITHOUT CUSTOM UNION

X2

X1
X3
X1
X6

X5

N1

X2

N6

N2

N5

N3
N4

X4
X4
X6
X5

X3

23
FIGURE 3: AFTA WITH CUSTOM UNION

Members can collectively decide which industries or products should

be imported and restrict the entry of industries or products that will
threaten the local industries.

24

Resource movement and Multinational corporations

(Non-direct Investment/Portfolio investment)
- involving normally financial assets such as purchase of stocks and bonds
denominated in national currency.
Bonds
- Investor lends capital and gets fixed payouts or a return at regular intervals
and then receives the face value of the bond at a prespecified date.
Stock
- Investors purchase equity or claim on the net worth of a firm.
Foreign Direct Investment or FDI
- Real investment in factories, capital goods, land and inventories where both
capital and management are involved and the investor retains control over use
of the invested capital.
- Foreign Direct investment or FDI are normally undertaken by multinational
corporations (MNCs) .
- United States Department of Commerce - "FDI should include all foreign
business organizations owning an interest of at least 10 percent in the host
country"
- IMF defines FDI as an investment that made to acquire a lasting interest in
an enterprise operating in an economy and have an effective voice in the
management of the enterprise.
- FDI is the major channel for international private capital flows
Motives for Portfolio Investment
- Yield (profit) maximization
- risk diversification (this explains why there is two way international flows)
Motives for FDI
- To exploit or utilize (abroad) some unique production knowledge or
managerial skill (Horizontal integration) over which corporation wants to
retain direct control.
Example: IBM owns unique technology to produce computer, so to serve the
foreign market better but at the same time does not want to release its secret

25

technology and patent to foreign producers, IBM has to involve in FDI. Other
example: Xerox, Toyota, Nissan, Mercedes, Matsushita, etc.
To gain control over foreign source of required raw materials or foreign
marketing outlets (Vertical Integration). Example: USA companies own
mines in Canada, Venezuela etc.
To avoid import tariff and other trade restrictions or tato advantage of
production subsidy.
To enter foreign oligopolistic market to share big profits.
To acquire foreign firm to avoid future competition or avoid loss of export
market.

Importance of Foreign Direct Investment

1) Employment - FDI creates job opportunities
2) FDI can improve the balance of payments account through promoting importsubstitution and export oriented industries.
3) Foreign investors bring with them additional capital can lead to a higher level of
investment. Foreign investors can develop and finance certain investment
projects that the host country may not be able to undertake.
4) Furthermore, MNCs normally come along with scarce productive factors such as
technological knowledge and business experiences that could contribute to
economic development. MNCs can sometimes be considered as reservoirs of
technology which can provide many times larger allocations for research and
development (R&D).
5) FDI help the development of local supporting industries (SMEs), thereby
promoting forward and backward linkages, which are crucial to sustain our
high rate of industrial growth.
Disadvantages of FDI
1. Problems Encountered By Local Investor- pressure of competition
- Local investor might not be able to compete due to lack of capital, and
experience.
- Skill development and experiences are very low among local investor
compare to foreign investor.

26

- Foreign investor willing to pay higher wages to attract domestic resident to

work with them and causing local investor losing workers.
2. Dependency Onto Foreign Capital
- In case of foreign investor withdrawals, the country will suffer and economic
growth distrupted.
3. Repatriation of Profits and earnings
- main reason for service account deficit in Malaysia BoP
- worth around RM20 billions annually
4. Unbalanced Foreign Direct Investment Into Sectors
- mainly in mobile industries, assembly type, low value added and labor
intensive
- less in technology and capital intensive industries
MNCs - multinational corporations
- main vehicle for FDI (MNCs involved in FDI activities)
- largest MNCs in the world:
MNCs
Annual Sale
% Foreign sale
US$ bill
- General Motor
178.2
28.6
- Ford
153.6
31.3
- Mitsui
132.6
39.4
- Shell
128
53.9
- Mitsubishi
120.4
34.5
- Exxon
120.3
87.1
- Gen Electric
90.8
27
- Toyota
88.5
56.9
- IBM
78.5
62.3
- BP
71.3
51.2
- Daimler-Benze
69
66.8
- Volk
- Mobil
- Siemen
- Matsushita

Industry
auto
auto
div
pet
div
pet
elect
auto
comp
pet
auto

27

Phillips Morris
AT &T
Sony
Fiat

51.1
50.6

78.9
39.9

elect
auto

Capital Flows and External Financing: The Five Asian Countries* (in US$
billion)
1994 1995

1996 1997e 1998f

-24.6 -41.3

-54.9 -26.0 17.6

47.4

80.9

92.8

Private flows (net)

Equity Investment
Direct equity
Portfolio equity

40.5
12.2
4.7
7.6

77.4
15.5
4.9
10.6

93.0 -12.1 -9.4

19.1 -4.5 7.9
7.0
7.2 9.8
12.1 -11.6 -1.9

Private creditors
Commercial banks
Non-bank private
creditors
Offcial flows (net)

28.2
24.0
4.2

61.8
49.5
12.4

74.0 -7.6 -17.3

55.5 -21.3 -14.1
18.4 13.7 -3.2

7.0

3.6

-0.2

Current account balance

External Financing (net)

15.2 15.2

27.2 24.6

Resident lending/other
(net)**

-17.5 -25.9

-19.6 -11.9 -5.9

Reserves excluding gold (- =

increase)

-5.4

-18.3 22.7 -27.1

-13.7

Source: Institute of International Finance, Inc, Capital Flows to Emerging

market economy, January 29, 1998.
e = estimate, f = forcast
*Indonesia, Malaysia, Philippines, Thailand and South Korea
**Including resident net lending, monetary gold, and errors and omissions

28

Output and Welfare Effects of International Capital Transfers

F

Nation 1

Nation 2
J
VMPK nation2

VMPK
Nation1
M
N

H
R

G
VMPK2

VMPK1

O
B

Total Capital Stocks of nations 1 and 2 combined

VMPK = Value of Marginal Product of Capital
- Total capital stock is OO. Nation 1 owns OA and its output is OFGA while
Nation 2 owns OA and its output is OJMA
- Transfer of capital as much as AB from nation 1 to nation 2 equalizes the
return on capital in the two nations at BE.
- As a result, world output increases as much as EGM of which EGR accrues to
Nation 1 and ERM to nation 2.
- increase in domestic product in Nation 2 ABEM, of which ABER goes to
foreign investors, leaving ERM as the net gain in domestic income in nation 2.

29

Balance of Payments
- summary statement of all the transactions of the residents of a nation with the
rest of the world.
Credit
- transaction that involves the receipt of payments from foreigners
- example: exports of goods and services, unilateral transfers from foreigners,
capital inflows
- entered with positive (+) sign
Debit
- transaction that involves payments to foreigners
- example: imports of goods and services, unilateral transfers to foreigners,
capital outflows
- entered with negative (-) sign
B of Payment Account comprises of:
- Current Account
- Capital Account
Current Account
- Merchandise trade balance (balance of payments)
- All goods exports or imports like agricultural products, machinery, autos,
petroleum, electronics, textile, etc
- services balance (imbangan perkhidmatan)
- Insurance, transportation, investment income
- Unilateral transfer balance (imbangan pindahan)
- Private transfer payments or government transfer payments (bantuan
kewangan atau good an pindahan yang diterima atau dipay oleh kerajaan atau
pihak swasta)
Capital Account
- Changes in the nations assets abroad and foreign assets in the country
- The nations assets include real estates, corporate stocks and bonds,
government securities, and ordinary commercial bank deposits.
- They include both long term and short term private and official sector
transactions

30

- Reserves is not included because its changes reflects government policy rather
than market forces
Official reserve account
- Includes convertible foreign currencies, such as US$, UK , Singapore $ etc;
reserve position in the international monetary fund (IMF); stock of gold
reserves held by bank negara; and special drawing rights.
Autonomous transactions
- All transaction in the current and capital accounts (except the unilateral
transfers)
- They tato place for business or profit motives and independently of B of P
considerations
- Autonomous items are also called items above the line
Accommodating transaction
- Transactions in the official reserve assets
- Also called items below the line
- They occur as a results of and for the purpose of balancing international
transactions
Statistical discrepancy
- when statisticians sum credits and debits, many times the two total do not
match.
- Since in principle total debits must equal total credits, statisticians insert
residual to mato them equal
- This correcting entry is called statistical discrepancy or errors and omissions
- It is treated as part of capital account because short term capital transactions
are generally the most frequent source of error.
How to obtain the overall balance of payments?
- (1) Merchandise account balance (export minus import) plus (2) Service
account balance plus (3) net transfers plus (4) long term capital balance plus
(5) net (short term) private capital plus (6) errors and omissions
note
- (1) + (2) = Merchandise and service account balance = (A)

31

- (A) + (3) = CA balance = (B)

- (B) + (4) = basic balance = (C)
- C + 5 + 6 = Overall BOP
Example: BoP in RM million
Item
1. Current Account
*Merchandise Balance ( Balance of payments)
-Exp
-Imp
*Balance on Services
- (various sub-items)
Balance on Goods and services
(Balance of payments & perkhidmatan)

1996

1997

1998

10,088
193,363
183,275
-18,371

10,273
217,712
207,439
-22,748

69,008
281,947
212,939
-22,338

-8,283

12,475

46,670

*Transfers (pindahan)

-2,943

-3,345

-9,876

Balance on current account

(Imbangan Akaun sgolda)

-11,226

-15,820

36,794

748

4,645

2,137

12,777
13,525

14,450
19,095

8,490
10,627

Basic Balance

2,299

3,275

47,421

*Private short term capital

*Errors and Omissions

10,317
-6,371

-12,913
-1,254

-20,633
13,513

Overall balance
(Imbangan overall)

6,245

-10,892

40,301

Net change in international reserves

(Perubahan bersih rizab antarabangsa)
(-ve = increase, +ve = decrease)

-6,245

10,892

-40,301

2. Capital Account
*Official Long term capital
(Modal jangka panjang rasmi)
- (various sub-items)
* Private Long term capital
Balance on long term capital

32

Total reserves (held by BNM)

70,015

59,123

99,424

33

Note:
Why increase in reserves (-ve) while decrease in reserves (+ve)?
- 1) as BNM receive more reserve (foreign currencies), it has to pay or
exchange with RM, thus BNM stock of RM declines, (thus -ve)
- 2) as people or public require more reserve (foreign currencies) from BNM,
BNM has give up its stock of reserves and in exchange receive more RM from
the public, thus BNM stock of RM increases, (thus +ve)
FOREIGN EXCHANGE MARKETS AND EXCHANGE RATE
Foreign exchange market
- market in which individuals, firms and banks buy and sell foreign currencies
- Composed of several monetary centers like Zurich, Frankfurt, Singapore,
Hong Kong, Tokyo, New York, etc
- Those centers are connected by telephone network and video screen.
3 Main Roles of FOREX market:
- payment clearance
- Credit facilities for export and import
- Provide risk aversion facilities such as hedging
Why do we need foreign currencies?
- To pay for import of good and services from other nations
- To make investment abroad
Levels of transactors:
- 1st level (at the bottom) such as tourists, importers, exporters, investors, etc.
They are the immediate users as well as suppliers of foreign currencies.
- 2nd level such as commercial banks, acting as the clearing house between users
and earners of foreign exchange
- 3rd level, foreign exchange brokers. The commercial banks even out their
foreign exchange inflows and outflows through the currency brokers.
- 4th level, central bank, acting as the seller or buyer of the last resort when
nations total foreign exchange earnings and expenditures are not equal which
ultimately will result in the increase or decrease of the level of the nations
reserves.

34

Central Bank
Brokers
Commercial Banks
Exporters, Importers, Tourists, Investors

Vehicle currency
- When the currency is used for transaction without involving the nation of that
currency at all, for example when US$ is used by Brazilian importer to pay a
Japanese exporter.
- US$ is currently the most dominant vehicle currency serving as a unit of
account, medium of exchange, and store of value not only for domestic
transaction but also for international private and official transactions.
- About 60 % of US$ is held abroad
- In 1995, 41 % of total world foreign exchange trading was in US dollars (19
% in Deutsche mark, 12 % in Yen, 7 % in sterling)
- The nation (of vehicle currency) benefit in terms of seignorage
Seignorage
- Benefit accruing to a nation when its currency is used as an international
currency
- For example, USA enjoys interest-free loan from foreigners on the amounts
of dollars held abroad.
Exchange Rate (US$ and UK)
- The number of dollars needed to purchase one pound or R = $/. If R = 1.5, it
means $1.50 is required to purchase 1 pound

35

Exchange Rate Equilibrium

- it is determined at the intersection of the nations aggregate demand and
supply curve for the foreign currency
D

R=$/

2.0
1.5

40

Million /day

- As the demand for pound increases the value of R increases

- For example, when US import of goods from UK increases, the demand curve
for pound shifted upward, causing an increase in the R.
Depreciation
- Increase in the domestic price of foreign currency
- In the above example, the US$ depreciates since now it requires US$2 to buy
1
LECTURE 13
Appreciation
- Decline in the domestic price of the foreign currency
- In the above example, UK pound appreciates as now it requires 0.5 (1/2)
pound to buy US$ 1.00 (compared to 0.67 (1/1.5) before)
Arbitrage
- Purchase of currency in the monetary center where it is cheaper and
immediately sell in the monetary center where it is more expensive in order to
obtain profit.
- Due to arbitrage, any two currencies is kept the same in different monetary
centers.

36

- For example (2 point arbitrage): dollar price of pounds were $1.99 in New
York, $2.01 in London, an arbitrageur would purchase pounds at $1.99 in NY
and sell them in London for $2.01.
- In triangular arbitrage: $1.96 = 1 in NY
0.2 = DM1 in London
DM2.5 = $1 in Frankfurt
-

0.2 = DM1
in London
(buy DM)

$1.96 = 1 in NY (Buy pound)

DM2.5 = $1
in Frankfurt
(exchange the DM for $)

So the arbitrageur would buy pound at $1.96 in NY, use 1 to buy DM5 in
London and exchange the DM5 for $2 in Frankfurt, thus realizing profit of $0.04
on each pound.
2 types of FOREX rates and transaction:
1) SPOT
- based on spot rates
- Delivery takes place immediately
- Normally within 2 3 days
2) Forward
- Delivery of the currency not immediately after purchase agreement
- Rates of exchange is determined on the date of signing but delivery of the
currency is done later in the future (normally 1,3, atau 6 month)
- The most common is 3 month

37

- It can be used for risk protection against exchange rate uncertainties for
exporters or importers
(forward) premium
- when forward rate is above the present spot rate, the foreign currency is said
to be at a forward premium
- Example: SR: $2 = BP1, while the 3 month FR: $2.02 = BP1, the pound is
said to be at forward premium of 2 cents or 1 % for 3 month or 4 % per year.
forward discount
- when forward rate is below the present spot rate, the foreign currency is said
to be at a forward discount
example: Spot rate : $2 = BP1 and 3 month FR: $1.98 = BP1, the pound is at 3
month forward discount of 2 cents or 1 % or at 4 % Forward discount per year.
LECTURE 14
Calculating FD or FP
- Forward discount or forward premium are usually expressed as percentages
per year from the corresponding spot rate and can be calculated as:
FD or FP = ((FR SR)/SR ) x (12/M) x 100
FR = Forward rate
SR = Spot rate (written usually as R)
M = number of month for the forward rate (1, 3 or 6 month)
Example 1:

Given the following information

SR:
FR3month :

RM6.00 / BP1.00
RM6.30 / BP1.00

What is the annual (forward) premium for the BP ?

FP = [(6.30 - 6.00) / 6.00 ] x 12/3 x 100% = 20 %

38

What is the (forward) premium for BP for 3 month period?

= 20 % x 3/12 = 5%
What is the (forward) premium for BP for 9 month period?
= 20 % x 9/12 = 15%

Example 2:

SR
:
FR(6 month) :

Yen 250 / RM1.00

Yen 240 / RM 1.00

What is the discount rate for RM for the period of 3 month?

(240 -250) / 250 x 12/6 x 100% x 3/12 = 2%
What determines Forward Rate?
- Average Expectation (consensus forecast) of what will happen to the spot rate
- Example: FR 1month ($1.56) < SR ($1.60) if the public expect that pounds spot
rate will depreciate by 4 cents by next 1 month.
- Or If the public expect pound to appreciate, then FR ($1.65) > SR ($1.60)
Hedging
- Avoidance of foreign exchange risk (for future payment (import) or received
payment (export))
- Any future payment in foreign currency needs to be hedged if there is
possibility that the future spot rate would be higher (domestic currency
depreciates)
- Siam Cements profit during 1994-97 was wiped out by the loss in foreign
exchange because the company had $4.2 billion foreign borrowing that was
not hedged.
Example:

SR: RM 5.80 / BP 1.00

39

Problem: malaysian importer needs to pay RM580,000 (BP 100,000) after 3 month.
There would be no problem if on the 90th day, spot exchange rate stays at
SR: RM 5.80 / BP 1.00
But if after 3 month:
SR: RM 6.40 / BP 1.00
This implies, additional of RM60,000 or (640,000 - 580,000) is needed to pay the
import from UK after 3month . So to avoid that risk, Malaysian importer needs to
do hedging:
Now, there are two ways to do:
1. Deposit BP 100,000 in bank and after 3 month, withdraw the money to pay
PROBLEM with this method: capital is stuck in the bank for 3 month and cannot be
used for rolling.
What is the better way?
2) Buy BP in future market (3 month).
Sign agreement today, buy BP 100,000 but delivery is after 3 month.
If BP is at 3 month forward rates is at 4 % per annum premium, then Malaysian
importer only need to pay an extra of?
Given 3 month forward premium for BP is 4% per annum , so the 3 month premium
3/12 x 4% = 1%
So the hedging cost is 1% x 580,000 = RM 5800

40

2) US Importer. Assume current spot rate is ($2.00/1.00)

- US importer who needs to pay in BP after 3 month can buy in future market
(3 month).
- Sign the purchase contract today, buy 100,000, but delivery is made after 3
month.
- If is at 3 month forward rates premium of 4% per annum, then US importer
needs to pay extra of only $2000 to buy in 3 month 100,000.
- ($202,000 exchange with 100,000) that is ($2.02/1.00)
hedging cost is only $2000, that is 1% from 200,000 for 3 month.

3) US Exporter. Assume current spot rate is ($2.00/1.00)

- US exporter who will receive 100,000 can do hedging if he is afraid that
the value of () will decrease in 3 month time.
-

He can sell in future market (3 month).

- If is at discount 4% per annum for the 3 month forward rate, then he will
receive $198,000 ( hedging cost is = $2000). Rf(3B) ($1.98/1.00).
Interest and exchange rate Arbitrage
Malaysia & U.K.

RM

vs

Investment in Malaysia will obtaain a return of: (1 + rm)

Where rm = interest rate di Malaysia
If want to invest in U.K.
Return (U.K.) =

F ( RM / Pound )
(1 rUK )
S ( RM / Pound )

Where: S(RM/) = Spot exchange rates RM for .

41

F(RM/) = Future rates RM for .

RUK = annual interest rate in U.K.
1. If

(1 rm )

F ( RM / Pound )
(1 rUK )
S ( RM / Pound )

investor will borrow from UK and invest in

Malaysia.
2. If

(1 rm )

F ( RM / Pound )
(1 rUK )
S ( RM / Pound )

investor will borrow from Malaysia and invest in

U.K.
3. If

(1 rm )

F ( RM / Pound )
(1 rUK )
S ( RM / Pound )

can invest any where.

Example:
If (RM/) = S(RM/)
Rm = 0.08,

rUK = 0.06

Return in Malaysia = 1.08 > return in U.K. 1.06

Investor invest in Malaysia.
F = 6.15, S = 6.00
UK

6.15
x1.06 1.0865
6.00

42

> 1.08
UK >
Speculation
Activities of buying currencies with the hope that the currencies value will increase
or selling currencies with the hope that the value will fall
Example:
Rf (3B) $2.02/1.00
- If a speculator expect that Rs after 3 month is $1.98/1.00)
- Today, He sell in future market (using 3 month F Rate i.e. $2.02/1.00)
- On the 90th day, he will buy at the expected spot rate i.e. $1.98/1.00 and on
the same day sell or deliver the pound as agreed in the future market at the
$2.02/1.00 (profit of 4 cents per ).
- Note: Speculator in the above case gain because his expectation prediction for
the spot rate on the 90th day was correct
- What will happen if the spot rate on the 90 th day is $2.08/1.00)? Then he
would lose 5 cents per pound.

Should speculators be shot?

- Entire regions can be bankrupted by just a few speculators whose only

objective is to enrich themselves and their wealthy clients. Currency
trading, beyond the level necessary to finance trade, is unnecessary,
unproductive, and immoral, and that speculators should be shot!
- Speculators blame the politicians for mismanaging the economy.
True fact:

43

- 90 % of nowadays foreign exchange transaction is undertaken by foreign

currency traders and speculators
- By 1995, currency trading was about 50 times the value of world trade,
implying that much currency trading occurs for the reasons other than to
provide liquidity for world trade.
- Speculators are able to mobilize between US$600 billion to US$1 trillion to
bet against currencies, for example selling a currency forward in the hope that
they can buy it back later at a cheaper rate.

US$
8,000

Currency Trading volume

Foreign Exchange Trading

6,000
4,000

2,000
World Trade

73

83

85

89

92

95

44

Who is likely to be the victim of currency speculators?

- Normally they attack currencies of the nations with economic imbalances that
offer them profitable opportunities.
- Generally they would not attack currencies that are underlain by credible
economic policies
- In the recent 1997 currency crisis event, speculators successfully attacked the
Thai, Indonesia, Malaysia, The Philippines and Korea currencies
- Speculators were not very successful in trying to attack Hong Kong currency
as Hong Kong possesses very strong reserves.

WORLD EXCHANGE RATE SYSTEM

1) Fixed (pegged)
ER fixed by government.
By selling and buying back mechanism influence S and D of curr in the
FOREX market.
Weakness: expensive to maintain
Note: Currently Malaysia is practising currency peg system (to the US $). To
ensure the success of the peg, Malaysia introduced "international
demonetization of ringgit" since sept, 1998, which implies that selling and
buying of RM can only be done and valid within Malaysian border. The
demonetization policy has been quite successful in stabilizing the RM and
without any substantial cost in terms of reserve. Prior to that, Malaysia
practised managed floating system.
2) Adjustable pegged AP

45

It is like fixed system but not necessary can not be changed

Nation will change the ER especially when there is BOP disequilibrium.
It's changed to BOP , employment , growth , inflation.
Weakness: can lead to destabilizing speculation.
Crawling Peg system is meant to overcome weaknesses in AP. It is like AP
but par values are changed by small amounts at frequent specified intervals
3) Managed Floating
There is no routine intervention by the government except the rate becomes very
high or very low.
The system might require a large amount of reserves.

4) Independent Floating
Free of government intervention.
Rates are determined merely by the market supply and demand of the
currencies.
2 benefits:
Can solve the problems of currency overvalue or undervalue automatically
through S and D of the currency
Can solve the BOP problem automatically because it can increase or decrease
the export and import prices of the commodities and services. When deficit
occurs, currency drops, import more expensive, export price cheaper, thus less
import and more export, so BOP improves
3 weaknesses:
Exchange rate risks for Exporter or importer.

46

Can worsen nation's terms of trade (it will fall when Ex. Rate falls).
Can weaken the economy especially when Ex Rate , leads to difficulty to
export, factories might close down, and in unemployment.

5) Gold Standard
exchange gold with money at the predetermined rate.
Example: 1 oz gold = A$20.00
1 oz gold = 4.00
So oz gold = 1 : A$5.00
Gold bought and sold to the public
Advantage : Exchange rate is stable.

point of export for gold

Dolar

Per pound

Dt

USA

St

$5.02

$5.00
$4.98

point of import for gold

0
System of Gold Standard

1 oz = $20.00 US
= 4

quantity (Pound)

47

Assume : 1 = AS$5.00
export cost for gold = 0.02 for oz.
If ER is US$5.03 : 1 , then US importers will pay import with gold. Say cost of
good = $5.00 US. Send gold to England with the cost of $0.02 US. Can save $0.01
US.
(5.03) (5.00 + 0.02)
If ER is US$4.97 = 1 , then importer from England will pay import with gold.
Say cost for the good is $5.00 US; so, buy gold = 1 ($4.97 US$). Send gold to US
with cost $0.02 US. So, total cost = $4.97 + 0.02 (thus, pay only $4.99 US).

Note:
The auto adjustment mechanism under gold standard is called "price-specie-flow
mechanism
The ER between two nations is based on the ratio of "amount or content" of pure
gold in a physical unit of nation's currency
For example: I BP contained 113.0016 of pure gold while 1 US$ contained 23.22
grains of pure gold, thus the ER ($/BP) is 4.87
This ER is called "Mint Parity"
If the price of shipping 1BP worth of gold between NY and London is 3 cents,
Then the ER will normally not fluctuate by more than the shipment price (3
cents)
Gold Standard operated from about 1880 to outbreak of WW1 in 1914.
The fixed ER of Bretton Wood system (BWS) or Gold Exchange Standard,
operated from the end of WWII (1947-1971)
BWS was initially based initially based on the gold exchange standard with the
USA played major role by maintaining the price of gold at about $35 per ounce

48

and be ready to exchange on demand $ for gold at that price without any
limitation
The system collapsed in 1971 due to the global expectation for US$ major
devaluation in the light of US huge BOP deficit.
Huge capital flight took place from USA.
Then world rely on floating system of ER.
Effects of Currency Devaluation:
1. Flow of goods and services: import (), export ().
2. International price for exported domestic goods and services ().
3. Domestic costs for goods and services ().
4. Demanded quantity for foreign reserves ().
5. Supplied quantity for foreign reserves (not sure).
6. Terms of trade (not sure).
7. Balance of Payments:
Depends on Marshall-Lerner Condition:
1) If (elasticity of demand for import
+ export elasticity) > 1, then
devaluation will improve balance of payments
2) If (elasticity of demand for import + export elasticity)
< 1, then
devaluation will worsen balance of payments problem
3) If (elasticity of demand for import + export elasticity) = 1, then
devaluation will have no effect on balance of payments
Balance of Payment Improvement
2 ways:
1. Cost Approach
2. Income Approach
Cost Approach:
2 ways:
a. Manipulating the Exchange rate (in Flexible Exchange Rate System)
b. Manipulating the price level (Inflation or Deflation)

49

(in Fixed Exchange Rate System or (Gold Standard)

Income Approach
When demand for export , (deficit will occur) then output, employment, income
of export sector . Then the overall economy i.e. overall output, employment,
income of non-export sector .
When of demand (good an services) for import (deficit will occur), implying
reduction in demand for import substitute, then output, employment, income
import substitution sector . Then the Overall output , employment, income .
When there is BOP surplus due to increase in export, then output, employment
and export sector income . As income , saving, and Domestic spending as
well as import will , (export - import)
Thus BOP surplus will automatically.

Relationship between Income and BOP

XM=SI
(BOP

(Net saving)

(+)
Net Expenditure
0

(1)

(S - I0)
(S-I1)
Y0 Y1 Y2
B

Y
Income

50

A
(-)

(X M)

When Y , (S I)
When Y , (X M)
Initially, equilibrium is at Y0,
when (X M) = (S Io) [BOP is balanced]
If I , (S - I0) shifts to the right (downward) to (S I 1), Y to Y1, thus there is
deficit (Y1B).
Deficit can be rectified:
1. X or M, shifting (X M) to the right, S or I, shifting (S I1) to the left
and intersect at Y1.
2. X or M, letting S and I intersect at Y2.