My Own Notes For MCom Sem II

Economics of Global Trade & Finance
(M.Com Part-I/ Sem.-II)
Asst. Porf. Vikas W.Ubale
M.Com (part-I/Sem.II)
MODULE FOREIGN TRADE MULTIPLIER

Q. 1] What is Foreign Trade Multiplier? Discuss its international repercussions (Apr -09,
Oct -09, Apr 10, Oct 10, Apr 11, April 12)
Ans: The original idea of Foreign Trade Multiplier was given by R. F. Kahn, this multiplier was
Employment Multiplier, which studies the effect of changes in employment on changes in
income.
( Y = ke E ), where Y stands for change in income, ke stands for Employment multiplier
and E stands for initial change in Employment. This was used by Lord Keynes for his idea of
Investment Multiplier. The concept of foreign trade multiplier was given by Mr. Leighton, which
is also called as Export Multiplier.
The foreign trade multiplier can be explained as follows:
If the exports of the country increase, inorder to meet the foreign demand, they will engage more
factors to increase the production. This will raise the income of the producers. This process will
continue and the national income increases by the value of the multiplier. The value of the
multiplier depends on the value of the marginal propensity to save and the marginal propensity to
import, there being an inverse relation between the two propensities and the export multiplier.
The formula for calculation of the Foreign Trade Multiplier can be explained as follows:
The national income in an open Economy is
Y = {C + I + G + (X-M)}, where Y = National Income, C = Nations Consumption, I = Nations
Investment, G = Governments Expenditure, X = Exports and M = Imports)
Since, Government doesnt strictly follow the rules of economics its involvement can be ignored.
Y = C + I + (X M)
YC=I+XM
S = I + X M ( S = Y C, Savings = Income Consumption)
S+M=I+X
1

Thus, at equilibrium Savings + Imports is equal to Investment + Exports

However, there are leakages and they leave national income. Thus when,
a. S + M > I + X (Contraction takes place)
b. S + M < I + X (Expansion takes place)
And hence, when we introduce the change then the equation will be as follows:
S + M = I + X
The marginal propensity to saving i.e. S/Y determines change in savings which is designated
as S while the marginal propensity to import determines the change in imports i.e. M/Y, hence
the new formula would be as follows:
(S + M)/Y = I + X
Y = M (I + X)
The foreign trade multiplier is a function of Marginal Propensity to Save plus Marginal
Propensity to Import Let Foreign Trade Multiplier be Kf
Kf = f(S +M)
Where, f stands for functional relationship S stands for Marginal Propensity to Save M stands for
Marginal Propensity to Import There is an inverse relationship between S + M and Kf , smaller
the S + M greater will be the Kf. Conversely greater the S + M smaller will be Kf. Hence the
formula for income propagation through foreign trade multiplier will be as follows:
Y = M (I + X)
Kf = M M M

Place for diagram.

International Repercussions
A countrys exports or imports affect the national income of the other country, affects the pattern
of foreign trade and national income of the first country. This is known as foreign repercussion or
the backward effect. The smaller the country in relation to the other trading partner, the
negligible is the foreign repercussion. But the foreign repercussions will be high in the case of
large country because a change in the national income of such a country will have significant
foreign repercussions.
In case there are 2 large countries A and B, where As imports are Bs exports and vice versa. An
increase in As domestic investment will cause a multiplier to increase in its income. This causes
an increase in the imports of A from B, which leads to an increase in income of B. Now with the
increase in the income of B, its imports will increase from A, which will induce a second round
increase in As income and so on
Implications of International Repercussions
1. The foreign repercussion effects suggest a mechanism for the transmission of income
variations of disturbances between trading countries. It implies that a boon or slump in one
country has repercussions on the incomes of other countries.
2. The policy implications of the repercussions effects suggest that export promotion policies
raise national income in the trading partners at a lower rate than by an increase in domestic
investment. The export promotion measures raise national income via the simple foreign trade
multiplier, whereas increase in domestic investments policies raises national income many times
in multiplier rounds via the repercussion effects
3. The repercussion effects also suggest that since the backwash effects ultimately dwindles to
nothing, automatic income changes cannot eliminate completely the current account BOP deficit
or surplus produced by an automatic disturbance.

Q. 2] Explain with the help of Foreign trade multiplier the relationship between the
income changes and balance of payments (Oct 11)
Q. 3] Explain Internal and external balance in terms of IS-LM and BP schedules (Apr -09)
Ans: To explain the Internal and External balance, it needs to be understood that LM curve
represents monetary policy, IS curve represents fiscal policy and the BP curve represents those
combinations of interest rate and national income that produce BOP equilibrium. Any increase in
income will increase imports and increase the BOP deficit by increasing the current account
deficit. On the other hand an increase in the interest rate will attract foreign investments and
there will be capital inflow there by increasing the capital account surplus. Any point above and
to the left of the BP curve represents surplus in BOP and a point below and the right of the BP
curve shows a BOP deficit. The way expenditure changing monetary and fiscal policies affect
BOP disequilibrium are discussed below.
Expenditure Changing Monetary Policy: Expenditure changing monetary policy affects the
money supply and interest rates. A contraction in monetary policy leads to BOP surplus and an
expansionary monetary policy to a BOP deficit.
Expenditure Reducing & Increasing Monetary Policy:
To reduce the expenditure the money supply is reduced, which increases the interest rate thereby
reducing investment and output. The reduction in investment and output, in turn, reduces income
and aggregate demand for imported goods. There is also a reduction in the domestic price level
which may lead to switching of expenditure from foreign to domestic goods. Consequently, the
countrys imports are reduced and exports are increased. Thus the current account trade becomes
surplus. Simultaneously, there is a reduced outflow of short-term capital with reduction in
imports and further creating a surplus in BOP. On the other hand, rise in domestic interest rates
increase the inflow of capital, thereby leading to a full surplus in BOP. In case of Expenditure
Increasing Monetary Policy this will be just the opposite of the above. This can be explained
with the help of diagram.
Place for diagrams

4

LM, I and BO is in equilibrium at point E, when there is expenditure reducing policy adopted
then the original LM shifts to LM1 and the new equilibrium is at E1. Since, E1 is on the left of
the BOP, there is a surplus BOP. The interest rate increases from OR to OR1, which generates a
capital account surplus with capital inflow. On the other hand the income reduces from OY to
OY1 and hence will tend to generate a current account surplus because of the reduction in
imports. Thus a contractionary monetary policy leads to BOP surplus. Similarly a expansionary
monetary policy leads to BOP deficit. If the monetary authority increases the money supply, the
LM curve shifts downwards and the new equilibrium point is at E2. Since E2 is on the right of
BOP, there is a deficit in BOP. The interest rate falls from OR to OR2 which leads to capital
account deficit with less capital flow. On the other hand the income rises from OY to OY2 and
thus leading to a current account deficit due to increase in imports. Thus expansionary leads to
BOP Deficit.
Expenditure Changing Fiscal Policy:
By changing government expenditure or/and taxation, the expansionary fiscal policy tends to
increase government expenditure or/and reduce taxes. On the other hand contractionary fiscal
policy relates to cut in government expenditure or/and increase in taxes.
Expenditure Increasing Fiscal Policy:
If the government follows a expansionary fiscal policy i.e. increase its expenditure and reduces
the taxes. As a result, the IS curve shifts upwards to the left as the IS1 curve which cuts the LM
curve at E1. This new equilibrium shows increase in interest rate to OR1 and rise in income to
OY1. The increase in interest rate leads to capital inflow thereby creating short run BOP surplus
on capital account. On the other hand, the rise in income increases imports thereby leading to
BOP deficit on current account. The net overall effect on the BOP will depend upon the elasticity
of the BP curve. If the BP curve is elastic, then the equilibrium point E1 is above and to the left
of the curve BP, there will be overall BOP surplus in an expansionary fiscal policy. In case the
BP curve is less elastic as shown in BP1 curve, the equilibrium point E1 being below and to the
right of BP1 curve, there will be overall BOP deficit.
Expenditure Reducing Fiscal Policy:
If the government follows a contractionary fiscal policy i.e. reduce its expenditure and in the
mean time increase the tax, which leads to capital outflow and thus deficit of to capital account.
The income level also falls, which reduces imports, thereby leading to current account deficit.
Thus the BOP falls.
In case the government follows a expansionary fiscal policy, then the capital account is in
surplus, income level rises leading to increase in imports and there by leading to a BOP deficit
on current account. Thus BOP moves in to a surplus.

This can be explained using the below diagram:

At the equilibrium point E, OR is the interest rate and OY is the national income, since the
government is adopting contractionary fiscal policy, then the IS curve shifts downwards to the
left to IS2 cutting the LM curve at E2. There is a fall in interest rate to OR2, which leads to an
outflow of capital and to capital account deficit. Income also falls to OY2 which reduces the
imports, thereby leading to a current account deficit. Thus the overall effect is a BOP deficit,
since E2 is below and to the right of the BP curve.
However, the effects will also depend upon the slope of the BP curve. In the mentioned case BP
curve is elastic. If the BP curve is less elastic such as the BP1 curve in the figures, the BOP
would be surplus as point E2 is above and to the left of the BP1 curve.
Q. 4] Explain the Trade off between internal and external trade balances (Oct 10, Oct
11)
Ans: The trade off between external and internal balances indicate the balance of indebtedness.
The balance of indebtedness is a stock convept . It gives the position of investment of ca country
or in country over the entire period or a long period. It gives the international investment position
in terms of external and internal balances.
When a country borrows or lends internationally, it will have short-run disequilibrium in its
balance of payments, as these loans are usually for a short period or even if they are for long
duration, they are repayable later on; hence the position will be automatically corrected and
poses no serious problem. As such a disequilibrium may also emerge if a countrys imports
exceed its exports in a given year. This will be a temporary one once in a way, because later on
the country will be in a position to correct it easily by creating the required credit surplus by
exporting more to offset the decicit. But even this type of disequilibrium in the balance of
payments is not justified, because it may pave the way for a long term disequilibrium. When
such disequilibrium occurs year after year over a long period, it becomes chronic and may
seriously affect the countrys economy and its international economic relations. A persistent
deficit will tend to deplete its foreign exchange and the country may not be able to raise any
more loans from foreigners.
A huge population and its high rate of growth in poor countries also have adversely affected their
balance of payment position, it is easy to see that an increase in population increases the need of
these countries for imports and decreases the capacity to export.
Another reason for a surplus or deficit in balance of payments may arise out of international
borrowing and investment. A country may tend to have an adverse balance when it borrows
heavily from another country, while the leading country will tend to have favorable balance, and
a deficit balance when the loan is repaid.

The balance of international indebtedness improves when country registers a net capital outflow
whether private or government. Its net credit position is enhanced and its net debtor position is
reduced.
The settlement of balance of payment account influences the balance of indebtedness. When
deficits are settled by reducing reserves in foreign countries or by increasing the reserves of other
countries in the country, the effect is that net investment credit side is reduced. It also means the
net investment of foreign countries is increased. Thus, a deficit in the balance of payment will
reduce the net creditor position or increase the net debt position.
However, only if a net capital outflow is accompanied by an equal, combined positive balance on
current, unilateral transfer and gold accounts will it serve to improve a countrys balance of
international indebtedness. Only if the payments deficit is settled wholly or in part by an export
of gold will the balance of international indebtedness be changed in its favour.
To know the latest position of investment, the present market values can be taken into account,
but then in this case the figures will not tally if the balance of indebtedness is prepared from the
past accounts of balance of payments. When deficit are financed by loss of reserves, the balance
of indebtedness remains unchanged. Balance of indebtedness can also be prepared for a short
period of time or for a long period of time. The long-term investment position is of less
immediate importance. Long term investments are unlikely to be withdrawn on short notice
and tend to respond more to long-range, basic economic considerations. The long term
investment position is of significance in determining the international flows of interest and
dividend payments, which appear in the current account of the balance of payment.
Q. 5] Discuss how a country use monetary and fiscal policy for internal and external
stability (Apr -10)
Q. 6] Explain the Monetary Fiscal policy mix in converting the disequilibrium in Balance
of Payments (Apr 11)
Ans: The BOP deficit can be bridged by strict fiscal and monetary discipline in order to control
aggregate demand within the economy. So long as the fiscal deficit is under control, the BOP
situation does not deteriorate.
Any disequilibrium in the balance of payments when it persists continuously is certainly
undesirable because of its disastrous effects on the countrys economy and orderly world trade.
Thus one of the basic problems of international economic policy is restoring even balance to a
country whose balance of payments is seriously and persistently in surplus or in deficit, since
both are bad for normal internal economic operations and international economic relations.
Especially a deficit or adverse balance of payments is more harmful to a countrys economic
growth and is therefore to be corrected sooner than later. For obvious reasons, an adverse balance
of payments has to be corrected by encouraging exports and/or discouraging imports.
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Role of Monetary and Fiscal policies

The various measures that may be used for correcting an adverse balance of payments are of two
kinds:
Monetary Policies:
a. Deflation
b. Exchange Depreciation
c. Devaluation
d. Exchange Control
Fiscal Policies:
a. Tariffs import duties
b. Import quotas
c. Export promotion policies & programmes
Monetary measures usually have two edged effects in improving the balance of payments
position. They boost up exports as well as check or curtail imports. Monetary measures however
function indirectly. Non-monetary measures, on the other hand are directly effective. But they
work one way only. Tariffs and quotas for instance, tend to restrict only imports. Export
promotion measures, on the other hand, enhance exports only.
Fiscal measures are considered more effective, significant and are normally applicable than
monetary measures in correcting the adverse balance of payments. Fixing of import quotas and
tariffs to check imports and launching upon export promotion programmes in perhaps the best
solution of correcting the
disequilibrium in the balance of payments. Devaluation of currency may be resorted to only
under abnormal conditions.
Q. 7] Discuss Mundell Fleming model (Oct 09, April 12)
Ans: Robert A. Mundell and Fleming J. Marcus introduced Mundell-Fleming model, is an
extension of IS-LM-BOP Model.
Mundell and Fleming have extended the IS, LM model to incorporate external balance by way of
incorporating BOP Schedule.
IS schedule represents investment and saving schedule LM represents Demand for and Supply of
money schedule BOP represents Balance of Payments schedule.
8

The intersection between IS and LM schedules determine internal balance which is shown by the
Point E at which rate of interest is OR and National Income is OY, since the point E is lying on
the left side of BOP, it shows that the economy is running a balance of payment into surplus.
Under these circumstances if the economy would like to achieve both internal and external
balance then it have four options.
Option 1: Place for diagrams
Diagram (a) shows appreciation in the foreign exchange rate such that BP curve shifts upward
and passes through equilibrium point E and intersects IS and LM curves. As such the internal
balance and the external balance are achieved.

Diagram (b) shows the central bank pursuing the expansionary monetary policy by lowering
down the rate of interest such that LM schedule shifts to the right and passes through IS and BOP
schedules thus at the point of intersection i.e. E1 once again internal balance and external
balance are achieved.
Diagram (c) shows that the government switches over to the expansionary fiscal policy such that
the IS curve shifts to the right upward and passes through the intersecting point E1 as such once
again internal and external balances are attained.
10

Diagram (d) shows the role of monetary and fiscal policy when there is a perfect capital mobility
i.e. BOP curve is a horizontal straight line going parallel to X axis. Initial equilibrium is at E at
which IS and LM schedules intersect each other with BP schedule given. When the central bank
follows expansionary monetary policy which shifts the LM schedule to the right leading to LM
schedule. When the government follows expansionary fiscal policy the IS schedule. With the BP
schedule given IS1 and LM1 schedules intersect at the point E1 leading to establishing internal
and external balance at a higher level with the national income increasing from OY to OY1.
Asst.prof. Vikas W. Ubale
MODULE FOREIGN EXCHANGE MARKET

Q. 1] Define the term Foreign Exchange.
Ans: Foreign exchange simply means foreign money. It can be defined as the mechanism
through which payments are effected between two or more countries having different currencies.
It not only includes foreign money but also near money instruments denominated in foreign
currency.
Definition:
The Foreign Exchange Regulation Act 1973 defines foreign exchange as follows:
Foreign exchange means foreign currency & includes:
all deposits, credits & balances payable in any foreign currency & any draft, travelers cheques,
letters of credit & bill of exchange, expressed or drawn in Indian currency but payable in any
foreign currency;
any instrument payable, at the option of drawee or holder thereof or any other party there to,
either in Indian currency or in foreign currency or partly in one & partly in the other.
It is clear from the above definition that foreign exchange refers to foreign money including
currency notes, cheques, bills of exchange, bank balances & deposits in foreign currencies.
Q. 2] State & explain in brief the instruments which are used for international payments
Ans: The instruments which are used for International Payments are as follows:
1) Foreign Bill of Exchange
2) Bank Draft
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3) Mail Transfer
4) Telegraphic Transfer
5) Letter of Credit
1) Foreign Bill of Exchange: It can be defined as a negotiable credit instrument with an
unconditional order in writing drawn by a drawer addressed to the drawee to pay a sum of money
on demand to the payee or to the undersigned at a future date for the held transaction. The
participants are as follows:
a. Drawer: The exporter of goods, drawing the bill of exchange to send a written order to the
drawee for making the payment at a future date
b. Drawee: The importer of goods, receiving the bill of exchange & acknowledging to making
the payment
c. Payee : The person receiving the payment, he can be a person whom the drawer indicates the
Drawee to make the payment to. The Drawer & Payee can be same.
2) Bank Draft: It can be defined as an order of a bank on its branch or any other bank to pay a
sum of money to the bearer of the bank draft on demand.
3) Mail Transfer: The transfer of money from one bank account to another bank account of the
same bank at two different places through post office by mailing the post card
4) Telegraphic Transfer: A telegraphic order of a bank to its branch or to correspondent bank to
pay a sum of money to a person concerned. The amount needs to be deposited in one bank
account & then telegraphic transfer can be used to transfer the money to the concerned persons
bank account.
5) Letter of Credit: It is an authorization letter issued by a bank of the importer for specified
money. The importer imports the goods & sends LOC to the exporter, the exporter gets the
money on presenting the LOC to his bank & the money is transferred by the importers bank to
the exporters bank.
Q. 3] Only Exporters & Importers are the main participants in the Foreign Exchange
Market Examine
Ans: The foreign exchange market facilitates the monetary transactions of foreign trade. It can be
defined as a mechanism through which foreign currency can be bought & sold. It comprises of
buyers & sellers & also includes the intermediaries through which the buyers & sellers of foreign
exchange are brought together.
The participants of the Foreign Exchange Market include:
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1) Customers
2) Commercial Banks
3) Central Banks
4) Bill Brokers
5) Discount Houses
6) Acceptable Houses
1) Customers: It mainly comprises of importers & exporters. They participate in the foreign
exchange market through bank services
2) Commercial Banks: They are supposed to be the most active players in the foreign exchange.
Since banks have wide network of branches all over the world, they can transact the foreign
exchange business smoothly, quickly & efficiently. They act as intermediaries for the importers
& exporters. Being an active player, they also achieve their objectives of Profitability & risk
bearing using foreign exchange market.
3) Central Banks: They are the main players in the foreign exchange market. One of the main
functions of the central Banks in the world is to maintain the external value of the domestic
currency using foreign exchange rate systems like:
a. Fixed exchange rate system
b. Floating exchange rate system
4) Bill Brokers: Their function is to bring buyers and sellers together to settle the foreign
exchange transaction, for which they charge a brokerage.
5) Discount Houses: They discount the foreign bill of exchange put forwarded by an exporter and
finances him before the maturity of the foreign bill of exchange. London Discount Houses are
an example of Discount Houses in London international money market.
6) Acceptable Houses: They lend their name and acknowledge the responsibility to make the
payment of the foreign exchange bill to the payee on behalf of the drawee, as they are financially
well to do firms and with a glaring reputation in the foreign exchange world.
Q. 4] What are the functions of the foreign exchange market?
Ans: The following three are the main functions of the foreign exchange market:
1) Transfer Function
2) Credit Function
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3) Hedging Function
4) Determination of Exchange rate
1) Transfer Function: The main function of foreign exchange market is the transfer of funds i.e.
purchasing power from one nation or currency to another. It is also called as money changing
function of a foreign exchange market. It is mainly commercial banks which operate as clearing
houses for Forex demanded & supplied in the course of foreign transactions.
2) Credit Function: Foreign exchange market also performs the function of financing trade. It is
called credit function. Exporters require credit when the goods are in transit. The exporters
usually allow ninety days to the importers to pay. After shipment the exporters can immediately
get credit from commercial banks, which in turn collect payment from importers. Thus forex
market permits time to the importers in making payment on the one hand & permit instant
payment to the exporters on the other.
3) Hedging Function: To hedge means to shoulder risk. Under the system of fluctuating exchange
rates importers & exporters are exposed to exchange risk. Importers are worried that the foreign
currency many appreciate in future & they will have to pay more in local currency. Exporters are
also worried that foreign currency may depreciate & they might receive less in local currency.
Foreign exchange market provides hedging facilities to protect importers & exporters against the
exchange risk. It is the function of the foreign exchange market to enter into forward contract to
sell the foreign exchange at a predetermined rate.
4) Determination of exchange rate: The most important function of foreign exchange market,
however, is determination of exchange rate. Exchange rate is basically the price of one currency
expressed in terms of another currency. Under the system of market determined exchange rate,
demand from all buyers of forex & supply from all sellers of forex determines the rate of
exchange.
Q. 5] Distinguish between spot and forward exchange market
Ans: Sport Exchange Forward Exchange
1)S. It is the day to day rate of exchange which is charged on the delivery of goods on spot.
1)F. A forward contract is an agreement between the seller of forex & the buyer of forex, the
seller agrees to deliver a specified amount of forex at some future date, the buyer agrees to pay in
other currency at the future date.
2) S.In actual practice the settlement takes place within two days in most of the forex market
2)F. It may be one month forward, 3 months forward, 6 months forward etc.
3)S. The buyer of forex has to pay immediately on the spot the amount in other currency.
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3)F. The payment depends upon the contract date

4)S. The exchange rate is the rate which is prevailing at the time of trade, hence known as spot
rate
4) F.The rate is agreed upon at the time of signing the forward contract but delivery / payment is
made at some date in future.
Q. 6] What do you understand by Arbitrage?
Ans: Arbitrage means the simultaneous buying and selling of foreign currencies with the
intension of making profit. When the prices of some product - a commodity, security or currency
differ in two different markets, one can make risk tree profit by buying the product in the low
price market & simultaneously selling it in the high price market, this process is called as
Arbitraging. The person engaged in arbitrage activity is known as the arbitrageur. Arbitrage can
take place in any commodity, security or currency if there are price differences. Arbitrage results
into price equalization as the price goes up in the low price market & falls in high price market.
The arbitrageurs play an important role in removing price discrepancies & bringing about price
equalization. Arbitrage is thus a very short term temporary phenomenon.
Currency Arbitrage: In forex market currency arbitrage takes place when the exchange rate
between two currencies differs in two different markets. The Currency arbitrage is of two kinds
viz. two way arbitrage (also known as two point arbitrage) & three-way arbitrage (also known as
three point of triangular arbitrage)
Interest Arbitrage: - There is a close interrelationship between exchange rates, interest rates. It
revolves around the theory of interest arbitrage. The theory of interest arbitrage slates that
interest rates for comparable short term investments in different countries & currencies must
differ by the same proportion as the spot rate differs from the forward exchange rate. In other
words, the annualized percentage difference between interest rates must be equal to the
annualized percentage difference between the spot rate & forward rate.
EXCHANGE RATE SYSTEMS
Q. 7] Define Foreign Exchange Rate
Ans: Exchange rate is the rate at which one countrys currency is exchanged against the other
countrys currency. It is expressed as the number of units of local currency per unit of foreign
currency. For example, $ 1 = Rs. 54/- In other words, it is the price of foreign exchange
expressed in terms of local currency.
Q. 8] Explain how demand for and supply of foreign exchange determine the Foreign
Exchange Rate
15

Ans: As per BOP theory there are twin market which determine the Exchange Rate. It can be
explained as follows:
The demand for foreign currency is represented in the diagram. On the X axis it represents the
quantity of Englands ounds () demanded by US and on the Y axis the exchange rate is shown.
The demand curve being a downward sloping curve from left to right, its clearly seen that when
the exchange rate is $2 = , the total quantity demanded by US is 1,000. As the exchange rate
falls to $1.5 = 1, the demand for Pounds () increase to 1,500.
The foreign currency is demanded because of the following reasons:
a. Import of goods
b. Import of services
c. Unilateral Payments (donations, gifts, etc.)
d. Miscellaneous (repayment of debts, purchase of assets in foreign countries, direct foreign
investments etc.)
place for diagrams

The supply of foreign currency is represented in the diagram. On the X axis it represents the
quantity of Englands ounds () supplied and on the Y axis the exchange rate is shown. The
supply curve being an upward curve from left to right, it can be seen that when the exchange rate
is $1.5 = 1, the total quantity supplied by England is 1,000. As the exchange rate falls to $2 =
1, the supply of Pounds () increase to 1,500.
16

The main reasons of increase in supply of foreign exchanges are as follows:

a. Export of goods
b. Exports of services
c. Unilateral receipts (donations, gifts, grants received)
d. Miscellaneous (FDI, Foreign Portfolio Investment, repayments of debt taken by other
countries etc.)
With the intersection of Demand curve and Supply curve, we can determine the Foreign
Exchange rate as shown in the following diagram:
F.E.R = f(Df. Sf)
F.E.R. stands for Foreign Exchange Rate
f stands for functional relationship
Df stands for Demand of Foreign Exchange
Sf stands for Supply of Foreign Exchange
M.Com MORE CLASSES
Economics of Global Trade & Finance Your partner in studies
The demand curve and the supply curve intersect each other at E. Hence the equilibrium
FOREX rate is $2 = 1. If the exchange rate decreases to $2.5 = 1, then the supply will increase
to point b, however, at that decrease the demand for Forex will fall from E to point a, showing
the increase in price of Pounds () and demand for Pounds falling. Also if the exchange rate
increase to $1.5 = 1, then the supply falls to point c, however in the mean time the demand for
Pounds () increases showing the fall in price leading to a rise in demand and fall in supply.
Q. 9] Explain the different Exchange Rate systems in brief

Ans: Broadly speaking there are two different types of Exchange Rate Systems:
17

Place for diagram

a. Fixed Exchange Rate System
b. Flexible Exchange Rate System
a. Fixed Exchange Rate System: As the name suggests under this exchange rate system, the
countries agree to keep their currencies at a fixed or pegged exchange rate. Since the values of
the currencies were pegged against gold, it was also called as Gold Standard Exchange Rate
system. This system prevailed till the First World War period. It had
3 different versions as follows:
i) Gold Specie Standard consisted of gold coins with fixed gold content
ii) Gold Bullion Standard consisted of paper currency fully backed by gold and were
convertible into gold
iii) Gold Exchange Standard in this domestic currency of the country concerned is linked with
the paper currency of another country which is fully convertible into gold
It used to function on the basis of Mint Parity Theory i.e. gold parity. For example, if $100 were
backed by 50 grams of gold and Rs. 100/- were backed by 10 grams of gold then the exchange
rate would be 1$ = Rs. 5/- as $100 backing was equal to Rs. 500/- backing. Automatic stability of
exchange rate and automatic equilibrium in BOP were the merits of gold standard.
b. Flexible Exchange Rate System: This system came into existence when the world switched
over to inconvertible paper currency standard. In this the exchange rate is determined freely by
the twin market fares of demand for and supply of foreign exchange in the foreign exchange
market. The exchange rate fluctuates as per the fluctuations in the demand for and supply of
foreign exchange. To understand this, its very important to understand the Purchasing Power
Parity Theory. There are 2 versions of PPP Theory, which are as follows:
i) Absolute Version
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ii) Relative Version

Q. 10] Explain the Mint Parity Theory
Ans: Under the Mint Parity Theory, it is assumed that the currencies of the two trading or
participating countries must be on the same mono-metallic standard i.e. gold or silver. The
exchange rate would be determined on the basis of the metallic content of the two currencies i.e.
the value of the each gold currency depends upon the gold contained by the respective
currencies.
For example: if $100 were backed by 50 grams of gold & Rs. 100/- were backed by 10 grams o
gold then the exchange rate would be 1$ = Rs. 5/- as $100 backing was equal to Rs. 500/backing.
Under this theory the foreign exchange rate fixed was allowed to fluctuate within very narrow
limits called the gold export point and gold import points. The points were determined on the
basis of transport, handling, loading, unloading, shipment of gold insurance etc.
Place for diagram

On the X axis the demand for and supply of Gold Dollar are shown while along Y axis foreign
exchange rate between Gold Dollar and Gold Rupee is shown. D shows the demand for Gold
Dollar and S curve shows the supply of Gold Dollar. R shows the Mint Parity i.e. fixed exchange
rate between Gold Dollar and Gold Rupee. R1 shows Gold Export Points and R2 shows the Gold
Import points. These are to and fro fluctuations in the fixed exchange rate which remain within
the very narrow limit
Q. 11] Explain the cases in favour and against of Fixed exchange rate
Ans: The Fixed exchange rate operated successfully under the strict rules, the following are the
advantages/in favour of Fixed Exchange Rate system
19

a) Stability
This system ensured stability, certainty and confidence in promoting international trade. The
trading partners knew how much they are going to receive or how much they are supposed to pay
as the rate is fixed.
b) Long term investment
This system paved the way for long term investments which facilitates growth of capital market.
c) No danger of speculation
There is no danger of speculation i.e. in future there will be no ups and downs in the foreign
exchange rate.
d) Internal stability
It leads to internal economic stabilization.
e) Underdeveloped countries
The lender and the borrower know how much they are going to receive and how much they are
supposed to get, since developing countries depend heavily on foreign loans and foreign capital.
The stable exchange rate promotes international lending and thus helps Underdeveloped
countries.
f) Small countries
Small countries like Belgium and Denmark foreign trade plays a very important role in their
national income. Stable exchange rate system becomes the right policy of such countries
g) Growth of Money and Capital Market
This system is very much essential for the up to date growth of international money and capital
market.
The Fixed exchange rate system is defective in following ways:
a) High Government interference
The fixed exchange rate is determined by the government and not by the market forces and hence
it is ill suited for the economic and political conditions of the country as per Milton Friedman
Q. 12] Explain the cases in favour and against of Flexible exchange rate
Ans: Flexible Exchange Rate system has the following advantages:
20

a) Twin Market Forces

Flexible exchange rate system works on twin market forces of demand for foreign exchange and
supply of foreign exchange in the foreign exchange market. Hence it represents the general
theory of value
b) Government Policies
In this system government of the countries are free to pursue their own fiscal and monetary
policies
c) Adjustment of BOP
It serves as an instrument of adjustment in the balance of payment
d) Solution for Disequilibrium
It helps to solve the problem of disequilibrium in the balance of payment
e) Less dependency of Forex reserve
It relieves the countrys dependency on foreign exchange reserves
f) Effective functioning of Forex market
This system paves the way for the effective functioning of foreign exchange market
Q. 13] What is Managed Flexibility?
Ans: Management Flexibility means the flexibility of foreign exchange is controlled. The system
of managed flexibility is between the two extreme situations of foreign exchange rate system.
a) The fixed exchange rate system
b) The flexible exchange rate system
OR is the equilibrium rate, when the foreign exchange rate fluctuates around the equilibrium
foreign exchange rate then the central bank intervenes in to the foreign exchange market. When
the demand for foreign exchange rate rises the central bank releases its foreign exchange reserve
and sells the foreign exchange into the market to tide over the increased demand for foreign
exchange. Conversely when the supply of foreign exchange rises it buys the foreign exchange
from the market. Thus the central bank keeps the fluctuations in the foreign exchange rate within
limit.
21

Place for Diagram

The managed flexibility can be of three types:
a) Adjustable Peg system
b) Crawling Peg system
c) Managed Floating
a) Adjustable Peg system:
Once the country has made its choice of either currency or basket of currencies, the exchange
rate is pegged to the chosen item. Under fixed exchange rate system, govt. attempts to maintain
this fixed value over a long period of time. The govt. may like to maintain it fixed forever & may
insist that it will never change the fixed rate. However, in reality, it is not possible to maintain
exchange rate fixed forever. Whether govt. likes it or not, circumstances force govt. to change the
exchange rate. In the case of fundamental disequilibrium in BO , the govt. is forced to adjust
the external value of its local currency in terms of other currencies. This approach is known as
adjustable peg. The adjustable peg system is also described as maximum devaluation system,
because the country waits for a long time trying to hold exchange rate fixed, then undertakes a
sudden big devaluation of currency. As the old peg or fixed exchange rate becomes non-feasible
the country moves on to a new peg or new equilibrium rate. The Bretton woods system of fixed
exchange rate was actually a system of adjustable peg. IMF allowed the member countries to
devalue their currency in case of fundamental disequilibrium in their balance of payments.
b) The system of crawling peg:
The system is also known as trotting peg or gliding parity. It is another variety of managed
flexibility. Here it is believed that sudden devaluation is bad & therefore should be avoided. A
country should not wait for an unduly long period of time until all its forex reserves are
exhausted. The theory of gliding parity advocates that the country should keep on adjusting its
exchange rate to new demand & supply conditions in forex market. The exchange rate should be
adjusted at frequent intervals, for example, once a month or once a fortnight. It is a system of
22

minimum devaluation, also known as the system of crawling peg or trotting peg. While the
adjustable peg system is closer to fixed exchange rate policy, the crawling peg system is closer to
flexible exchange rate policy. Under the crawling peg system exchange rate is changed often
according to a set of indicators or to the judgment of the monetary authority.
c) Managed Floating:
Under managed floating, exchange rate is basically determined by free market forces of demand
& supply in the forex market, but govt. intervenes in forex market to influence the market
determined exchange rate. Thus, the float is not clean. It becomes dirty by government
intervention. Of course, the degree of government intervention differs from country to country &
from time to time.
Under the managed floating exchange rate system, the nations monetary authorities are
entrusted with the responsibility of intervening in forex market to smooth out short-run
fluctuations without attempting to affect the long term trend in exchange rates. Any short run
excess demand for forex can be met with supply of forex from the reserves. It would moderate
the tendency of the local currency to depreciate. Any short run excess supply of forex in the
market can be absorbed in to forex reserves thereby moderating the tendency of local currency to
appreciate. Thus, central bank can stabilize short run fluctuating in exchange rates by using forex
reserves. This is known as the policy of leaning against the wind. As per the managed flexibility
the forex rate is allowed to fluctuate but within limit.
CONVERTIBILITY OF A CURRENCY
Q. 1] Define Currency Convertibility
Ans: A convertible currency is one which can be converted into foreign currencies and can be
used freely for payment against import of goods and services.
Q. 2] Distinguish between Partial Convertibility and Full Convertibility of the currency
Ans: Partial Convertibility Full Convertibility
1)P. It is the day to day rate of exchange which is charged on the delivery of goods on spot.
1)F. A forward contract is an agreement between the seller of forex & the buyer of forex, the
seller agrees to deliver a specified amount of forex at some future date, the buyer agrees to pay in
other currency at the future date.
2) P.In actual practice the settlement takes place within two days in most of the forex market
2) F.It may be one month forward, 3 months forward, 6 months forward etc.
23

3)P. The buyer of forex has to pay immediately on the spot the amount in other currency.
3) F.The payment depends upon the contract date
4) P.The exchange rate is the rate which is prevailing at the time of trade, hence known as spot
rate
4)F. The rate is agreed upon at the time of signing the forward contract but delivery / payment is
made at some date in future.
Q. 3] Write notes on Prerequisites and Merits of currency convertibility
Ans: The Prerequisites for making the currency convertibility a grand success are as follows:
1) Domestic stability of an economy
2) Adequate stock of foreign exchange reserves
3) When foreign exchange reserves are not adequate then the imports should be restricted in a
country and should import only essential commodities
4) Current Account position of balance of payment should be comfortable
5) Conducive and appropriate industrial and investment policies
6) Development planning should be export oriented such that incentives should be given for the
promotion of exports
The merits of convertibility are as follows:
1) It encourages exports by increasing profitability of exports
2) It leads to import substitution and export promotion
3) It gives incentive to Non-Resident Indians to remit funds
4) Before convertibility Hawala Market remains very active to the remittance of funds now after
convertibility remittance of funds gets done through proper channel
5) It assigns real value to the currency
Q. 4] Explain the term Foreign Exchange Reserve
Ans: The term foreign exchange reserve is associated with the system of international payments
of a country. It is a part and parcel of international liquidity.
24

International liquidity a broader concept refers to generally accepted means of international

payments available to a country for the settlement of international transactions, it consists of two
elements
a. Owned reserves
b. Borrowing facilities
Of these two elements the foreign exchange reserves constitute only Owned reserves. It consists
of the following:
a. Official holding of gold
b. Foreign exchanges like US dollars, Pound sterling and other strong or reserve currencies of the
world countries.
c. Special Drawing Rights (SDRs)
d. Reserve Position in IMF
Q. 5] Write a note on the Reserve position in IMF
Ans: The reserve position of IMF can be had from each member countrys contribution to IMF,
in terms of fixed quota. Each member countrys quota is fixed on the following grounds:
a) 2% of national income
b) 5% of gold and dollar reserves
c) 10% of average annual imports
d) 10% of maximum variation in annual exports
e) The sum of (a), (b), (c) and (d) increased by the percentage ratios of average annual exports of
national income
The quotas of all member countries taken together determine the major financial resources of the
fund. Each member country is required to subscribe its quota partly in gold and partly in 25% of
its quota or 10% of its gold stock and US Dollar holdings, whichever is less. The portion of
subscription paid in nations currency is deposited in nations central bank on behalf of IMF.
Quotas of selected member countries of IMF:
As on December 31, 1972 in million US
25

Countr
y
USA
UK
German
y
France
Japan
Canada
Italy
India

Quot
a
6700
2800
1600
1500
1200
1100
1000
940
Gold
Sub
1672
700
400
375
300
275
250
162
1 SDR = 0.888671 gram of fine gold

Source: IMF International Financial Statistics Feb. 1973
(For latest info: http://www.imf.org/external/np/sec/memdir/members.aspx)
Q. 6] Explain importance of SDRs
Ans: To cater to the growing need of international liquidity to finance the balance of payments
deficits and other international financial obligations, SDR (Special Drawing Rights) were
introduced.
SDR is an international reserve asset created by IMF by taking into account the global need to
supplement the existing reserves and thus to alleviate the problem of international liquidity.
The SDR is a created deposit of the IMF. It confers on the holder the right to obtain its defined
equivalent in foreign exchange from other member countries of IMF. It is only a book entry in
the Special Drawings Account of the IMF. The allocation of DRs takes the form of credit entry in
the DRs Account of the Fund.
The features of DRs are as follows:
a) There is no need to furnish any adequate collateral security when the SDRs are issued to any
member country.
b) It can be freely used by the creditor country to meet its balance of payment details.
c) It doesnot require prior approval of IMF for using a SDR and also the member country need
not adopt any specific economic policy for the same
26

d) A participant member country having a need to use SDRs toward balance of payments deficit
can approach a designated member of the fund for the supply of the required foreign exchange.
e) The fund designates members to provide the foreign exchange in exchange for SDRs on the
basis of strength of their balance of payments and reserve position.
The importance of SDRs are as follows:
a) To obtain currency in transactions through agreement with other members, without any
requirement for balance of payment deficit.
b) For swap arrangements
c) In forward operations
d) To make loans of SDRs
e) To settle financial obligations
f) As security for the performance of financial obligations in either of the two ways:
a. Members may pledge SDRs which is recoded in a special register kept in the IMF
b. SDRs may be used by members as security against performance of obligation
The SDR is known as paper gold as it is substituted for gold as the most important international
monetary asset. The main objective of IMF behind the issue of SDTs is to provide adequate
reserves to member countries to facilitate the expansion and the growth of international trade.
The allocation of SDRs supplements the exiting international reserves. It also reduces the
dependency of the member participating countries on US dollar as the international means of
payments.
The value of SDR is determined on the basis of a basket of five currencies vis the US dollar, the
Deutsch Mark, the French Franc, the Japanese Yen and the British Pound Sterling.
Q. 7] Define Exchange Risk
Ans: Exchange Risk can be defined as the rate at which a currency is exchanged for another
country may be uncertain volatile and the amount that an exporter receives in domestic currency
or an importer has to pay in terms of domestic currency will be unpredictable and uncertain.
Similarly, if funds are transmitted from one country to another, the amounts to be set or to be
received will not be certain, if exchange rates are not fixed. But in the present global economy,
free market forces operate to determine the exchange rates depending upon the supply and
demand for the currency. This will lead to fluctuating rates, which may result in profits or losses
to the holders of foreign currency.
27

Q. 8] What are the types of exchange risks

Ans: The different types of exchange risks are as follows:
a) Credit risk of customer: Credit rating by international banks and international credit rating
agencies will help reducing this risk
b) Country risk: This is slightly different from currency risk and arises out of the policies of
economic and political nature and their external payments position and their export earnings to
service the foreign creditors, convertibility or otherwise of their currencies etc.
c) Currently risk: This risk arises out of the volatility or otherwise of the currency and its strength
or weakness in terms of other currencies and interest rates and relative degrees of inflation in the
respective countries which influence the exchange rates. It also depends on the hot money flows
and speculative short term flows as between countries which will destabilize the exchange rates.
d) Market risk: Risk of commodities, their quality and change of government policies of taxation
etc., are borne by the exporters. It will thus be seen that some risks cannot be avoided or passed
on by the exporters and in fact many more risks are to be borne by the importers than by the
exporters.
Q. 9] State the financial instruments used by the foreign exchange market to link it globally
Ans: The financial instruments used by the foreign exchange market to link it globally are as
follows:
1. Spot: In spot transaction the trade represents a direct exchange between two currencies, has
the shortest time frame, involves cash rather than a contract; and interest is not included in the
agreed upon transaction
2. Forward: One way to deal with the foreign exchange risk is to engage in a forward transaction.
In this transaction, money does not actually change hands until some agreed upon future date. A
buyer and seller agree on an exchange rate for any date, regardless of what the market rates are
then. The duration of the trade can be a one day, a few days, months or years. Usually the date is
decided by both parties.
3. Future: Foreign currency futures are exchange traded forward transactions with standard
contract sizes and maturity dates. Futures are standardized and are usually traded on an exchange
created for this purpose. The average contract length is roughly 3 months. Future contracts are
usually inclusive of any interest amounts.
4. Swap: The most common type of forward transaction is the currency swap. In a swap, two
parties exchange currencies for a certain length of time and agree to reverse the transaction at a
later date. These are not standardized contracts and are not traded through an exchange.
28

5. Option: A foreign exchange option is a derivative where the owner has the right but not the
obligation to exchange money denominated in one currency into another currency at a pre-agreed
exchange rate on a specified rate on a specified date. The FX options market is the deepest,
largest and most liquid market for options of any kind in the world.
6. Exchange Traded fund: Exchange traded funds are open ended investment companies that
can be traded at any time throughout the course of the day.
7. Speculation: Speculation have a stabilizing influence on the market and perform the important
function of providing a market for hedgers and transferring risk from those people who dont
wish to bear it, to those who do. Large hedge funds and other well capitalized position traders
are the main professional speculators.
Asst. Prof. Vikas Ubale
MODULE
CURRENCY MARKET
Q. 1] Explain the important features of Euro-Currency Market. What are the factors that
contributed to its growth? (A-09, O-09, A-10, O-10, A-11)
Ans: Euro-currency market is an international financial market specializing in the borrowing and
lending of currencies outside their countries of issue Euro currency market is primarily a post
war phenomena and came to be known as Euro dollar market. Thus the Euro dollar market is
more broadly called the Euro currency market as it also includes currencies other than the dollars
such as Pounds, Francs, Yen. However, the Euro dollar portion of the Euro currency is the
dominant one. But a Euro currency system is not necessarily is located in Europe, it extends far
beyond its original European location with centers open for business at almost any time in the
middle east and south east asia, as well as Canada and Japan, however its origin is in Europe.
Features of Euro-Currency Market

1. International Market: Euro currency market has emerged as the most important channel for
mobilizing and deploying funds on an international scale. By its very nature for eg: the euro
currency market is outside the direct control of any national monetary policy It is aptly said that
the dollar deposits in London are outside US control because they are in London, and out British
control because they are in dollars. The growth of market owes a great deal to the fact that it is
outside the control of any national authority.
2. Short term Money Market: the deposits in this market range in maturity from one day to
several months and interest is paid on all of them,. Although some Euro currency deposits have a
29

maturity of over one year. Euro currency deposits are predominantly a short term instruments.
Euro currency market is a credit market a market in dollar bank loans- and as an important
assessor to the Euro bond market. Euro dollar loans are generally for short periods i.e 3months or
less. Euro bonds being employed for long term loans. The Euro bonds developed out of the euro
currency market to [provide longer term loans than was usual with euro dollar. These bonds are
usually issued by a consortium of banks and issuing houses.
3. Wholesale market: Its a whole sale market in the sense that the Euro dollar is a currency dealt
in only large units. The size of individual transaction is usually above $1million dollar.
4. Highly competitive: Euro currency market is sensible market.Its efficiency and
competitiveness are reflected in its growth and expansion. The resiliency of the euro dollar
market is reflected in the responsiveness of the supply of an demand for funds to the changes in
the interest rates.
Factors that contributed to the growth of euro currency market:
1. Suez crisis:- The restrictions placed upon sterling credit facilities for financing trades which
did not touch the britishers during the Suez crisis in 1957 provided a stimulus for the growth of
euro dollar market. The British banks in search of an alternative way to meet the demand for
credit on the part of the traders in this sphere easily found a good substitute in dollars.
There was already available a pool of US Dollars held by residence outside the US.
2. Exchange controls and currency convertibility:-The general relaxation of exchange control the
stability in the exchange market and the resumptions of currency convertibility in western
Europe in 1958 provided an added impetus to the growth of the Euro Dollar market. In a
convertible currency system, some countries are as a rule in surplus and others indeficiate. The
money market in the surplus country being liquid, short term funds flow to the euro market,
attracted by the higher rate of interest .On the other hand, credit flows from the euro market to
the deficit countries where the money market is right. The relaxation of exchange controls not
only enabled the holder of the dollar claims to retain them rather than surrendering the dollar to
the exchange control authorities, but also increased the demand for US dollars as they could be
freely converted into domestic currency to finance domestic economic activity
3. Political Factors: The cold war between US and the communist countries also contributed to
the growth of the euro market. Due to the fear of blocking or seizure of deposits by the US in the
event of hostilities, the Russian and the east European banks sought to place their dollar balances
with European banks especially British and French rather than with banks in the US.
4. Balance of Payment deficits of the US: The large and persistent deficit in the BOP of the US
meant an increasing flow of the US dollars to those countries who had surplus with the US. The
US has had a deficit in International payments every year since 1950, except in 1957 since 1958
30

the deficit assumed alarming proportions. This is one of the most important factors responsible
for the rapid growth of Euro Dollar market.
5. Innovative Banking: The advent of innovative banking spearheaded by the American banks in
Europe and the willingness of the banks in the market to operate on a narrow spread also
encouraged the growth of Euro market.
6. Supply of Petro dollars: the flow of petro dollars facilitated by the tremendous increase in the
O ECs oil revenue following the hikes in the Oil prices since 1973 has been a significant source
of growth of the Euro dollar market. Oil price rise in 1973 which was followed by frequent
escalations and the resultant huge current account surplus of the OPEC who came to place their
funds in the Euro currency market proved to be an unprecedented boon. The OPEC surplus rose
from US $64b. in 1974 to $120b. in 1980 with a corresponding availability of large funds to the
Euro currency markets providing burgeoning liquidity to the International banks operating in the
market.
Q. 2] What is meant by currency area? Discuss the emerging trends in currency area (O-09,
O-10, O-11)
Ans: Currency areas refer to a group of countries, whose currencies are permanently linked
through a fixed exchange rate system among themselves. The currencies of member countries are
linked with the currencies of the non-member countries on the basis of flexible exchange rate
system. Currency area may be linked through a common currency such as the Euro of the EC
countries. Currency area is a territory or region in which one monetary unit of a currency
circulates with fixed rate and its is integrated through trade and factor movements. The
currencies of member countries may be linked with non-member countries may be linked with
non-member countries on a flexible exchange rate system. The membership of an OCA may
involve benefits and costs. A country joining the OCA or economic unions gains greater
monitory efficiency under a fixed exchange rate as compared to a flexible exchange rate with a
nonmember country,. The monetary efficiency gain will be all the more higher if such factors as
labour and capital can move freely between the country joining the OCA and its other members.
The EU also known European Economic Community, is a successful example of a currency area.
The first step towards this direction was the establishment of a band of exchange rate
fluctuations known as the snake in the tunnel in 1972. This arrangement continued after the
collapse of the Bretton Wood system in 1973, with the participating EEC counties jointly floating
relative to the rest of the world. It was simply an arrangement but not the integration or
coordination of monetary and fiscal policies of the union. Member countries moved out of this
arrangement with the change in circumstances.
With the formation of EMS (European Monetary System) in 1979 official transactions with the
union, the ECU (European Currency Units) came into use. The EMS worked well because
members were free to peg their exchange rate bands to the new snake. The Maastricht
31

Agreement of 99 was ratified by all members by the end of 1993. The Euro, common currency of
EEC came into existence on 1st January 1999 and the EEC became the EU. The importance of
Euro Currency Market in the international economy has increased over whelming. Its future is
linked with the future of world economy as a whole. Indeed, development of the market has been
so much amazingly rapid that it has now become the focus of considerable controversy. Its size,
rapid growth and freedom from national regulations have attracted interest in its Macro
Economic implications and its impact of its policies of individual countries. It will continue to
play a major role in the world economy scene so long as worlds international transactions or the
integration of world economy proceeds as smoothly as they have in the past. The important role
of the EC market in the international lending is well brought out by the fact that of the total
international bond issue and placements more than one half was in the Euro dollar issues and
placements. It is obvious that the sound development of the world economy cannot be
maintained without the smooth functioning of the Euro Currency Market.
The development of currency market indicates the extent of monetary interdependence of the
economies of the world. The degree of its development is such that for the proper management
and monitoring of the world economy, effective coordination between the monetary and other
policies of the major countries of the world is essential. Agreements of some form of coordinated
surveillance and official intervention in the currency market may well prove the beginning of
laying the foundation of further cooperation in coordinating economic policies of the countries of
the world. Until there is some consensus agreement among the concerned the countries regarding
the overall role of euro currency market as an international capital market there is, little chance
of progressing in the direction of formulating specific regulatory measures for the markets.
The positive effects of currency markets are in the form of increased international capital
mobility, integration of capital markets, reducing interest differentials among nations and help in
financing balance of payment deficits. The flows of Euro dollars have some adverse effects also.
According to Milton Friedman, the Euro dollar market has almost surely raised the worlds
nominal money supply (expressed in dollar equivalent) and has this made the world price level
(expressed in dollar equivalent) higher than otherwise it would be. This has obviously created
difficulty in monetary regulation by different countries.
Q. 3] Explain Euro currency and Euro equity Capital (O-11)
Ans: For Euro Currency refer to Q.12 & 13
Euro equity Market: Euro-issue is an issue where the securities are issued in a currency of the
country of issue and the securities are sold internationally to corporate and private investors in
different countries. A Euro issue is different from a foreign issue where the issuer is not
incorporated in the country in which the securities are being issued, but the securities are
denominated in the currency of the country of issue and are aimed at domestic investors in the
32

country where the issue is made. Euro securities are transferable securities which are to be
underwritten and distributed by a syndicate.
The major benefit that a Euro issue provides to the issuer company is the ability to raise funds at
a lower cost. Average coupon rates on convertible bonds of five year maturity in the Euro market
are 2.5% to 4% as against the domestic long term interest rate of 14% or more. The cost of 8% to
14%, thus providing a mechanism for raising equity at a cost which is lower than the cost of
making a rights issue. Also, a Euro issue can be priced at par or even at a slight premium
depending on the market conditions. Besides these benefits, issuer companies which can enlarge
the market for its shares through greater exposure and at the same time, enhance its image in the
international markets. International listings can provide increased liquidity for the securities, thus
making them more attractive to buyers. From an investors angle, a Euro issue provides them a
simple means to diversify their portfolio globally, and have access to foreign markets which were
closed to foreign investment until now.
Q. 4] Explain Euro Currency, Euro Equity and Euro bond Markets (A-12)
Ans: Currency Market refers to the mechanism through which payments of global trade are
settled. It is the system of materializing global trade and financial transactions in international
institutions and Commercial Banks realized the need for a common currency to settle
international trade transactions.
Euro currency market is an international financial market specializing in the borrowing and
lending of currencies outside their countries of issue, The prefix Euro thus refers to external
indicating that the market is not a constituent of the domestic financial system and is thus free
from the domestic banking regulation.
The Euro-currency market is primarily a post war phenomenon and came to be known as Eurodollar market. Thus the Euro-dollar market is, more broadly called the Euro-currency market as
it also includes currencies other than the dollars such as pounds, Francs, Yen. However, the eurodollar portion of the Euro-currency is the dominant one. But a Euro-currency system is not
necessarily located in Europe, it extends far beyond its original European location with centers
open for business at almost any time in the Middle East and South East Asia as well as Canada
and Japan. However its origin is in Europe.
Constituents of Euro Currency Market
1. Euro Currency: Funds in the Euro Currency market are funded by banks in the form of loans
and Merchant Bankers help in the loan syndication. To play in the international capital market
the major things that are important are the choice of currency and the choice of financial
33

instrument and in the selection of these, only the merchant bankers skills, expertise, experience
and resource position is reflected. There are lot of new instruments which came into existence
and choice has to be made to economies the cost and quick availability of funds depending on
the need profile of the user.
2. Euro Equity: With liberalization having opened the floodgates of overseas market, more
companies are moving towards the mobilization of funds from the international market in the
form of Euro issues- GDRs. This would in turn lead to Merchant bankers to be fully conversant
to deal in Euro issues. However, there are some barriers which are restricting the growth of the
euro-equity market. The heavy cost and time involved in reaching the investors, difficulty for
investors in making the decision to invest in a particular currency, standardizing of various
systems, complications of various regulations in other nations etc. are some of the reasons. These
could be overcome once the Merchant Bankers develop expertise in these areas
3. Euro Bond: Merchant Bankers can enter into the international bond market as lead managers.
There are various centers which provide technical facilities and depending upon the borrowers
country of origin, funds requirement, location of stock exchange. All Eurobonds are required to
be listed on one or more stock exchange for easy trading. To enter the areas of international
market, the Merchant Banker has to follow the two steps namely to participate in international
groupings and association with other merchant Banks operating in International Market.
Q. 5] What are the characteristics of the Euro-currency Markets (A-12)
Ans: The important characteristics of the currency market are as follows:
1. International Market: Currency market has emerged as the most important channel for
mobilizing and deploying funds on an international scale.
2. Short-term Money Market: The deposits in this market range in maturity from one day to
several months and interest is paid on all of them. Although some Euro-currency deposits have a
maturity of over one year. Euro-currency deposits are predominantly a short-term instrument.
Euro-currency market is a credit market a market in dollar bank loans and as an important
accessory to the Eurobond market. Euro-dollar loans are generally for short periods three
months or less. Euro-bonds being employed for longer term loans. The Euro-bonds developed
out of the Euro-currency market to provide longer term loans than was usual with Euro-dollars.
These bonds are usually issued by a consortium of banks and issuing houses.
3. Wholesale market: The Euro-currency market is a wholesale market in the sense that the Euro
dollar is a currency dealt in only large units. The size of an individual transaction is usually
above $1 million
4. Highly Competitive: Euro-currency market is sensible market. Its efficiency and
competitiveness are reflected in its growth and expansion. The resiliency of the Euro dollar
34

market is reflected in the responsiveness of the supply of and demand for funds to the changes in
the interest rates.
Asst. Prof. Vikas W. Ubale
MODULEEMERGING ISSUES IN GLOBAL TRADE

Q. 1] Write a note on Tariffs
Ans: Tariffs refers to the duties or taxes which are imposed on internationally traded
commodities when these goods cross the national boundries.
Classification of Tariffs: place for T diagram
35

Q. 2] What are the effects of Tariffs?

Ans: The following are the effects of Tariffs:
1. Price Effect
2. Protective Effect
3. Revenue Effect
4. Consumption Effect
5. Income and Employment Effect
6. Transfer Effect or Redistribution Effect
7. Terms of Trade Effect 8. Balance of Payment Effect
Q. 3] What do you mean by Non-Tariff Barriers? Explain them briefly (April 09)
Ans: Non tariff barriers are in the form of quantity restrictions such as quotas, import licensing,
counselor formalities trading blocks, state trading, export obligation exchange control etc.
Tariffs are not very effective in under developed countries. Their problems are different from the
problems faced by the developed countries. The problem before the developed countries is to
maintain the already attained high rate of economic growth while the problem before the
undeveloped countries is to accelerate the rate of economic growth. Hence, NTBs can be
divided into two categories NTBs for Developing countries (for preventing foreign exchange
outflows or those which result from the chosen strategy of economic development) and NTBs
for Developed countries (for protecting domestic industries which have lost international
competitiveness and/or which are politically sensitive for governments of these countries)
The measures which are used other than tariffs to restrict imports collectively are referred as nontariff barriers. These are direct measures of import restrictions. These can be further divided into
two forms (a) those NTBs which restrict imports directly (b) those which restrict imports by
encouraging domestic production.
The following are the types of import quotas:
1. Tariff Quota: In this case, imports of commodity up to certain amount, is permitted under a
low rate of tariff duty. Any further increase in imports beyond the given quantity is charged at a
higher rate of import duty. Thus, its a combination of tariff as well as quota.
36

2. Unilateral Quota: A Quota which is fixed without negotiation with the foreign trading partner
is called Unilateral Quota. There are two types of Unilateral Quota (a) Global Quota (b)
Allocated Quota.
Under Global Quota a fixed amount of goods can be imported from any country. Under
Allocated Global Quota a fixed amount of goods to be imported is rigidly fixed and the exporting
country is also fixed and hence there is also a fear of creation of monopoly.
3. Bilateral Quota: Bilateral quota implies negotiation between both the trading countries
regarding the fixing of quota of the commodity to be imported. An importing country levies
bilateral quota in consultation with the exporting country.
4. Mixing Quota: Mixing quota combines the features of the domestic raw materials and the
imported spare parts from the exporting country. The assembling takes place in the domestic
country. Mixing Quota is advisable in order to boost up domestic production. It also saves
precious and scarce foreign exchange.
5. Import Licensing: Import licensing is import quota regulatory system. Under this system the
prospective imports would be required to obtain import license from the authority and this exerts
a better control over imports.
1. Foreign Exchange Restrictions: Exchange control measures are used by many developed
nations to regulate their imports and keep their balance of payments in controllable limits. In this
the importer has to ensure that adequate foreign exchange would be made available to him for
the import of goods by obtaining a clearance from the exchange control authorities of the country
before concluding the contract with the supplier.
2. Technical and Administrative Regulations: In this the importing country specifies certain
standards on the imported commodities and which they must satisfy before their import is
permitted. It may be like a standard on technical production, technical specification etc. It can
also be administrative restrictions such as adherence to certain documentary procedure which are
to be adopted to regulate imports. These technical and administrative measures impede the free
flow of trade to a large extent.
3. Consular Formalities: In this along with shipping documents it must accompany the consular
documents such as certificate of origin, certified invoices, import certificates etc. In case the
documentation is faulty or not drawn in the language of importing country, heavy penalties are
imposed and also fees charged on these documentations are quite heavy.
4. State Trading: Separate state agencies are setup for each class of products. These agencies
carry on the international trade strictly according to the government policies. A few other
countries of the world follow state trading in a restricted sense to achieve certain desired results
especially where bulk imports are needed and government wants to maintain price stability. For
37

eg. Some articles, as decided by the government, are imported only through State Trading
Corporation (STC), similarly exports of raw materials such as iron ore, mica etc. are canalized
only through Minerals and Metals Trading Corporation (MMTC).
5. Preferential Arrangement: In multilateral trading system, a few member countries agree to a
small advantageous group for their mutual benefit. The member countries of the group negotiate
and arrive at a settlement of preferential tariff rate to carry on trade amongst them. These rates
are much lower than ordinary tariff rates and applicable only to the member nations of the small
group. Such type of preferential arrangements is outside the purview of the WTO.
Q. 4] Discuss the process and progress of globalization in India and China(April 09, Oct 09)
Ans: Most of the global economies have chose to turn their economic systems towards the
market economy and global economy. These countries include Eastern European countries,
Vietnam, Peru, Mexico, Brazil, India, Ethiopia, Morocco, Chile, Spain, Cuba etc. India had
observed these developments in the global economies and responded favourably to these changes
in 1991.
Sequence of reforms in china:
The First Phase (1978-1993) Economic reforms in China began with reforms in agricultural and
rural development
1978 : Dismantled the Rural peoples Communes and allotted land reforms on long-term
contract, with right of inheritance. Adopted Dual Track ricing Mechanism, under which agents
were permitted to sell part of the produce in the open market.
1979 : Special economic Zones (SEZs) set up in Shenzen, Zhuhai, Shantou, and Xiamen to
attract FDI. Foreign players allowed to make own investment-production and marketingdecisions in these zones. Flexible labour laws introduced in these zones.
1984 : Free Trade Zones opened in 14 post cities along the North and South-Eastern coast and
Hainan island
1985 : State monopoly on purchase and marketing of grains, cotton etc. replaced by a system of
contract purchase Agriculture products allowed to be bought and sold freely State subsidies on
agricultural products totally withdrawn
1987 : Contract system introduced among all newly recruited workers in state owned enterprises
M.Com MORE CLASSES
38

1988 : Made Hainan island a separate province and a declared the whole island a Special
economic Zone
1991 : Direct subsidies to exporters stopped
1993 : Central Bank of China given greater powers; influence of local governments over
monetary and credit policies reduced The Second Phase 1994 : A single VAT of 17 per cent
introduced in place of a host of indirect taxes. Share of national and local governments changed
to 75:25
1995 : large scale privatisation of loss making SOEs. Lay-off begin 1996 : current account
convertibility allowed and averaged customs duty reduced from 36 percent to 23.4 percent
1997 : Launched programme to convert large industrial enterprises into conglomerates while
releasing others Bureaucracy streamlined to reduce the number of officials by half
1998 : Grain distribution system reformed, new channels for capital circulation opened, housing
commercialised and a medicare programme introduced 1999 : Recapitalisation of national banks
started by creating four asset management companies
2000 : Two government bonds issued to finance the governments infrastructure activities
Private Individual Wholly Invested Enterprise Law brought into effect Individuals allowed to set
up private companies and tap the capital market Indian industries does not have much to show its
efforts towards globalization except its success in software projects. But Chinese consumer
durable industry like Haier, Galantz, TCL and Konka are exporting to Asia and Europe with
these phenomenal developments. China poses a threat to India not only in the Indian market, but
also in the foreign markets
Economic Reforms in India
The First decade (1991-2001)
1991 : New Industrial policy announced Foreign investment up to 51% in select industries
allowed PSU reserve list cut from 17 to 8 FIIs allowed to invest in market PSUs brought under
SICA
1992 : Steel industry decontrolled Wealth tax abolished Free pricing of IPOs allowed 100%
private equity in core sectors like steel, telecom and power permitted Five year EXIM policy
announced
1993 : Companies Act amended Rupee made convertible on trade account Excise duty simplified
by merging special and basic duty
39

1994 : Private telcos allowed to compete with state owned COS Lending rates deregulated
Automatic approval announced for foreign investment upto 51% Rupee made convertible on
current account Drug industry delicensed
1995 : Modified carry forward trading system allowed Insurance regulatory body mooted
1996 :74% foreign equity in 9 industries, and 51% in16 more permitted
1997 : Coal sector privatised Maximum income tax rate cut to 30% and corporate tax to 35%
Restrictions on import of 69 goods lifted New takeover code approved 1998 : New prudential
norms for NBFCs notified FII investment in treasury bills cleared FDI norms under automatic
route simplified Trading in derivatives by FILLs cleared Norms on foreign equity participation in
airline sector overhauled 100% FDI in cigarettes allowed 74% foreign equity cap announced for
TV software firms Up to 40% FDI in private
M.Com MORE CLASSES
banks allowed ISP policy frees tariffs, allows private gateways Insurance, patent reforms cleared
1999 : IT ministry launches a Rs. 100 cr VC fund for start ups IRDA (Insurance regulatory and
development) bill passed Foreign Exchange Regulatory Act replaced by the Foreign Exchange
Management Act Department of Disinvestment created to oversee privatisation of public sector
enterprises Excise rate slab cut from 11 to 3-8%, 16% and 24%
2000 : VC cos. made exempt from income tax as well as dividend tax Rs. 150 cr. R and D fund
set up Minimum daily requirement for maintaining cash reserve ratio balances slashed from 85 to
65% Inter-bank gold trading by banks allowed Scheduled commercial banks allowed to float
insurance subsidiaries Special economic zones to be created with 100% foreign equity
Quantitative Restrictions (QRs) on 714 tariff lines at the 8 digit level lifted Single window
clearance for import of capital goods at a flat rate of 5% announced Indian industry has to meet
the competition of Chinese industry. There are three options to India. They are:
- Collaboration with China by forming regional trade block on the lines of ASEAN.
- Collaborate with USA / Japan, acquire competencies and meet the competition.
- Collaborate with some of the industries of other countries.
Globalisation has brought in new opportunities to India and China. Greater access to developed
country markets and technology transfer hold out promise improved productivity and higher
living standard.
40

1. Liberal Economy: Globalisation made India and China more economically liberal. These
liberalization measures include scrapping of the industrial licensing regime, reduction in the
number of areas reserved for the public sector, amendment of the Monopolies and the Restrictive
Trade Practices act (MRTP), start of privatization etc.
2. GDP growth rates: GDP grew from 4.6% in 1990-91 to a peak level of 77.8% in 1996-97. A
global comparison shows that India is the second fastest growing economy after China.
3. FDI: Over the past decade FDI flows into India has averaged around 0.5% of GDP against 5%
for China, where as FDI inflows into China now exceeds US $50 billion annually. It is only US
$4 billion in the case of India.
4. Agriculture: replicating the reforms model of China may not be possible for India at this
moment, but certainly applying the insights from their experience is worth doing, which will
certainly create an environment conducive to achieve the growth rate of 9% per annum in this
decade.
Q. 5] What is strategic trade policy? Analyse its significance for developing countries (Oct
09, Oct 10, April 11)
Ans: Strategic Trade Policy refers to the system of government interference in foreign trade. The
nature of government interference or trade policy has very broad implications it has impact not
only on the volume and composition of imports and exports but also on the pattern of investment
and direction development, competitive conditions, cost conditions, entrepreneurial and business
attitudes, consumption patterns etc. While the need for government interference in the trade, as in
other sectors, of the developing countries is well recognized, there is no agreement on the type of
trade strategy or the nature of the government interference in trade that is suitable for the
developing countries.
The choice of the trade strategy is one of the most important economic policy decisions a
developing country has to make because of its wide implications indicated above. The trade
policy is only one of the elements of the macroeconomic policy mix all the elements of the mix
should be mutually supportive for the development strategy to be successful.
Under protectionism, the domestic industries are protected from the competition of foreign
goods. The home industries are granted protection in any one or more of the following ways:
1. Protective Duties: When the government, with a view to make the imports costly imposes
duties on the imports of foreign goods, such duties are called Protective Duties. Such duties may
be advalorem (on the value of imports) or specific (on the weight or measurement).
2. Commercial Prohibition: Sometimes, the government prohibits altogether the imports of
certain commodities with a +
41

3. Quota System
4. License System
5. State Trading
6. Discriminatory Transport Charges
7. Devaluation
8. Exchange Control
Q. 6] Explain the impact of non-tariff barriers on import and export of developing
countries (April 10, Oct 11, April 12)
Ans: Non tariff distortions occur due to imposition of non tariff barriers. The non tariff
barriers are in the form of quantitative restrictions such as quota, license, foreign exchange
restrictions consular formalities, technical and administrative regulations. The following are
some of the major non tariff restrictions:
1. Exchange Permit: Exchange permits are very important to the exporters. In order to conserve
scarce foreign exchange and to solve balance of payment difficulties, many countries have
imposed restrictions on the use of their currency.
2. Quotas: Quotas are quantitative restrictions. Quotas involve a limitation either on the value or
the quantity of a commodity that may be imported or exported from the country during specified
period of time.
Import quota is a protectionist device under which only a fixed amount of goods and services
may be imported. Import quotas are of two types (i) autonomous quotas fixed by law and (ii)
agreed quotas, fixed by trade agreements between the countries
3. Consular Formalities: In many countries consular documents have to be obtained by the
importers like import certificates, certificate of origin, certified consular invoices etc.
Documentation fee payable by the importers is also quite high.
4. State Trading: In many socialist countries of the world, foreign trade is not only regulated but
also exclusively handled by state enterprises. In such
Economics of Global Trade & Finance Your partner in studies countries, the nature and extent of
international trade is influenced by government policies.
5. Dumping: It is the process of selling goods abroad at a price lower than the selling price at the
home market. It doesnt imply selling at a loss, or selling at cost price; being charged from the
42

home market. Such a dumping by its very nature is not a permanent feature of international trade.
The producer does not have the intention to keep on selling the goods below the home price for
all times to come.
Q. 7] Compare the process of liberalization and globalization in India and China (April 11) or
Analyse the process and effects of globalization of India and China (Oct 11)
Ans: The Chinese adopted a path of embracing the process of globalization in late 970s by
liberalizing their economy. Today, China is about to enter the WTO with the status of a
developed country.
Refer to Q. 4 for remaining part of the answer
Asst. Prof. Vikas W. Ubale
43

My Own Notes For MCom Sem II

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MODULE FOREIGN TRADE MULTIPLIER

Economics of Global Trade & Finance

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Thus, at equilibrium Savings + Imports is equal to Investment + Exports

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Place for diagram.

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Place for diagrams

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This can be explained using the below diagram:

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Role of Monetary and Fiscal policies

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Economics of Global Trade & Finance

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MODULE FOREIGN EXCHANGE MARKET

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3)F. The payment depends upon the contract date

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place for diagrams

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The main reasons of increase in supply of foreign exchanges are as follows:

Q. 9] Explain the different Exchange Rate systems in brief

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Place for diagram

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ii) Relative Version

Place for diagram

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a) Twin Market Forces

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Place for Diagram

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