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International Economics, Comparative cost theory, Foreign Trade, Exchange…
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Comparative cost theory
Ability of a country to produce at lower opportunity cost than its competitors, even if there is no absolute advantage - David Ricardo
Absolute Advantage theory - Adam Smith
- Country produce best of their ability
- It will benefit both the countries by exchanging their best produce with each other
Assumptions:
- There are only two countries and two commodities
- There is no governmental intervention in export and import Only labour is factor of production. Quantity of labour used gives cost of production.
- There is perfect mobility of labour within the country but not between the countries.
- There is no cost of transportation between the countries.
- The law of constant returns to scale operates in production.
- The units of labour are homogeneous
- The units of each commodity in both countries are homogeneous
Foreign Trade
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Benefits of International trade
The prime reason for any country to engage in International Trade is because there is a need or want of goods or services
- Optimal use of the natural resources of a country
- Availability of different types of goods and services
- Specialisation in the production of certain goods and services
- Stability in prices of products and services
- Exchange of technical expertise
- Exchange of technical expertise
- Development of transport and communication
- Improved relations
Disadvantages:
- Economic and political dependence
- Improper utilisation of nation's resource
- Import of sub standard and poor quality goods
- Impediment in development of industries locally
Features:
- Trade between two or more nations
- Different monetary units
- More restrictions
- Restrictions on release of foreign currencies
- Multiple regulations
- Flow of capital across countries
- Shaping the policies of the Government
- Huge investment
- Requirement of accurate and timely information
- Larger size
- Wider scope
- More potential
- Market segmentation
- Market Expansion
Exchange rate:
Foreign Exchange Rate is defined as the price of the domestic currency with respect to another currency
Types:
- Fixed
- Floating
- Managed
- Fixed exchange rate:
Merits
- Ensures stability
- Helps control inflation
- Stops speculating
- Promotes capital movement
- Helps preventing capital outflow
Demerits
- Requires high reserve of gold
- Result in undervaluation or overvaluation of currency
- Discourage free markets
- Difficult to tackle depression or recession
- Floating Exchange rate
Merits
- No need to hold any reserve
- Eliminates the problem of overvaluation or undervaluation
- Encourages free market
Demerits
- It encourages speculation
- No stability due to fluctuation
- Macro policies become inconvenient
- Uncertainty discourages international trade
Exchange Control
- Direct method
- Indirect method
1. Direct method
- Intervention
- Restriction
2.1 Blocked accounts
2.2 Multiple exchange rates
2.3 Allocation of exchange according to priorities
2.4 Payments agreement
- Indirect method
2.1 Tariff and Non Tariff
2.2 Export subsidies
2.3 Increase in Interest rate
Effect of exchange rate
- Impact on volume of trade
- Affects the relative price of product domestically and internationally
- Affects the demand of the goods
- Export oriented economy will gain from depreciation
- Import oriented economy will face inflation in short tern for depreciation
- Impacts the fiscal health of the country through current account deficit and surplus
- Affects foreign investment
- Makes forecasting more difficult
EuroDollar
- US dollars deposited in foreign banks
- Used as credit instruments by non residents
- Lending in eruo dollar market were cheaper
- Used to finance their imports
- Less regulations
- Helps deposit countries in BOP deficit balancing
- Enhances global liquidity
Risk in Euro dollar
- Risk of excess credit
- Lack of financial discipline due to less regulation
- Exchange rate fluctuation