Balance of Payments of India

Introduction:
In the modern world, there is hardly any country which is self-sufficient
in the sense that it produces all the goods and services it needs.

Every country imports from other countries the goods that cannot be
produced at all in the country or can be produced only at an unduly high
cost as compared to the foreign supplies.

Similarly, a country exports to other countries the commodities which

those countries prefer to buy from abroad rather than producing at
home. Besides, trade of goods and services, there are flows of capital.
Foreign capital flows are in the form of portfolio investment by foreign
institutional investors or in the form of foreign direct investment. The
balance of payments is a systematic record of all economic transactions
of residents of a country with the rest of the world during a given period
of time.

This record is so prepared as to measure the various components of a

country’s external economic transactions. Thus, the aim is to present an
account of all receipts and payments on account of goods exported,
services rendered and capital received by the residents of a country, and
goods imported, services received and capital transferred by residents of
the country. The main purpose of keeping these records is to know the
international economic position of a country which helps the
Government in making decisions on monetary and fiscal policies on the
one hand, and trade and payments policies on the other.

Balance of Trade and Balance of Payments:

Balance of trade and balance of payments are two related terms but they
should be carefully distinguished from each other because they do not
have exactly the same meaning. Balance of trade refers to the difference
in values of imports and exports of commodities only, i.e., visible items
only. Movement of goods between countries is known as visible trade
because the movement of goods is open and visible and can be verified by
the custom officials.

During a given period of time, the exports and imports may be exactly
equal, in which case the balance of trade is said to be in balance. But this
is not necessary because those who export and import are not necessarily
the same persons. If the value of exports exceeds the value of imports, the
country is said to have an export surplus. On the other hand, if the value
of its imports exceeds the value of its exports, the country is said to have
a deficit balance of trade.

Distinction between Current Account and Capital Account:

The distinction between the current account and capital account of the
balance of payment may be noted. The current account deals with
payment for currently produced goods and services. It includes also
interest earned or paid on claims and also gifts and donations.

The capital account, on the other hand, deals with capital receipts and
payments of debts and claims. The current account of the balance of
payments affects the level of national income directly. For instance, when
India sells its currently produced goods and services to foreign countries,
the producers of those goods get income from abroad.

In other words, current account receipts have the effect of increasing the
flow of income in the country. On the other hand, when India imports
goods and services from foreign countries and pays them money which
would have been used to demand goods and services within the country
money flows out to foreign countries.

Thus, current account payments to foreigners involve reduction of the

flow of income within the country and constitute a leakage. Thus, the
current account of the balance of payments has a direct effect on the level
of income in a country. The capital account, however, does not have such
a direct effect on the level of income; it influences the volume of assets
which a country holds.

Balance of Payments on Current Account:

Two types of Balance of Payments are distinguished:
(1) Balance of Payments on Current Account, and

(2) Balance of Payments on Capital Account.

We first explain the meaning and components of balance of payments on

current account.

Balance of payments on current account is more comprehensive in scope

than balance of trade. It includes not only imports and exports of goods
which are visible items but also invisible items such as foreign travel,
transportation (shipping, air transport etc.), insurance, tourism,
investment income (e.g. interest on investments), transfer payments i.e.
donations, gifts, etc.
A country, say India, has to make payments to the other countries not
only for its imports of merchandise but also for tourists travelling abroad,
insurance and shipping services rendered by other countries. Further, it
has to pay the royalties to foreign firms, expenditure of Indians in foreign
countries, interest on foreign investment in India. These are debit items
for India, since the transactions involve payments made to the rest of the
world. In the same way, foreign countries import goods from India, make
use of Indian films and so on, for all of which they make payments to
India.

An important item which has recently emerged as an item of invisible

exports is software exports which has become good foreign exchange
earner. These are the credit items for India as the latter receives
payments. Balance of payments thus gives a comprehensive picture of all
such transactions including imports and exports of goods and services
concerned.

The Table 2.4 (given below) gives the position of India’s balance of
payments on current account for the years 2007-08 to 2011-12. In this
table balance of payments the visible as well as invisible items of trade
are given. The visible items are export-import of goods and the invisible
items of balance of payments on current account are travel,
transportation and insurance, interest on loans given and other
investment income on private and official transfers.

Both visible and invisible items together make up the current account.
Interest on loans, tourist expenditure, banking and insurance charges,
software services etc., are similar to visible trade since receipts from
selling such services to the foreigners are very similar in their effects to
the receipts from sales of goods; both provide income to the people who
produce the goods or services.
It will be noted from Table 2.4 above that the most important item in the
balance of payments on current account is balance of trade which refers
to imports and exports of goods. In Table 2.4 balance of trade does not
balance and shows a deficit in all the seven years. In the years 2011-12
and 2012-13 trade deficit has substantially increased. Trade deficit was
over 10 per cent of GDP in both these years.

In fact, it is huge trade deficit in these two years that has caused huge
current account deficit of over 4% of GDP in these two years. Economic
slowdown in advanced countries and its spillover effects in Emerging
Market Economies coupled with high crude oil and gold prices were
responsible for sharp increase in trade deficit.

Due to surplus in invisibles account, there was a surplus on current

account during 2001-2002, 2002-03 and 2003-04. In India’s balance of
payments on current account from 2004-05 onwards there has been a
deficit. Contrary to popular perception, deficit on current account is not
always bad provided it is within reasonable limits and can be easily met
by non-debt capital receipts. In fact, deficit on current account represents
the extent of absorption of capital inflows in India during a year.

It may be noted that when there is deficit on the current account, it is

financed either by using foreign exchange reserves held by Reserve Bank
of India or by capital flows that come into the country in the form of
foreign direct investment (FDI) and portfolio investment by FIIs,
external commercial borrowing (ECB) from abroad and by NRI deposits
in foreign exchange account in our banks.

However, due to global financial crisis in 2008-09, there was first

slowdown and then decrease in exports. As a result, there was a large
deficit of 2.4 of per cent of GDP on current account which could not be
met by capital inflows as they were quite meagre ($ 8.6 billion) as a result
of global financial crisis. Therefore, to finance the deficit on current
account in 2008-09 we had to withdraw US $ 20 billion from our foreign
exchange reserves. Again, in the two years 2011-12 and 2012-13 the
current account deficit (CAD) had been quite high.

It may be noted that high current deficit tends to weaken the rupee by
raising the demand for US dollars. In 2011- 12, the current account deficit
tended to weaken the rupee by raising the demand for US dollars. In
2011-12, the current account deficit was 4.2 per cent of GDP. Since
capital inflows in this year were not adequate to finance the current
account deficit, RBI had to withdraw 12.8 billion US dollars from its
foreign exchange reserves to meet the demand for US dollars.

In the year 2012-13 the current account deficit has been estimated to be
even higher at 4.8 per cent of GDP, capital inflows through portfolio
investment by FIIs had picked up in the latter half of 2012-13 but capital
inflows through FDI had fallen. However, we managed to meet such large
account deficit through capital inflows. In fact we added to our foreign
exchange reserves by $3.8 billion in 2012-13.

Thus current account deficit poses serious challenge to macroeconomic

management of the economy. The dependence on volatile capital inflows
through FIIs to meet the current account deficit is unsustainable as these
capital flows go back when global situation worsens and thereby cause
sharp depreciation in exchange rate of rupee and crash in stock market
prices.

Since in the recent years, 2011-12 and 2012-13 current account deficit has
widened, this has increased the balance of payments vulnerability to
sudden reversal of capital flows, especially when sizable flows comprise
debt and volatile portfolio investment by FIIs. The priority has therefore
been to reduce current account deficit (CAD) through improving trade
balance. Efforts have been made to promote exports by diversifying the
export commodity basket and export destinations.

One way to limit imports is to bring domestic prices up to the

international level so that users bear the full cost. Accordingly, petrol has
been decontrolled and diesel prices have been revised upward in Jan.
2013 to curtail subsidy on it. To discourage the imports of gold which has
played a significant role in causing trade deficit, customs duty on its
import was raised from 6% to 8% and further to 10% in July 2013.

Further, to improve the current account deficit emphasis has been on

facilitating remittances and encouraging software exports that have been
responsible for surplus on the invisible account. In recent years this
surplus has lowered the impact of widening trade deficit on current
account deficit (CAD) significantly.

The two components together met nearly two-thirds of the trade deficit
that was more than 10 per cent of GDP in 2011-12. Remittances
particularly are known to exhibit resistance when the country is hit by
external shock as was evident during the global crisis of2008.
Balance of Payments on Capital Account:
In the balance of payments on capital account given in Table 2.5
important items are borrowings from foreign countries and lending
funds to other countries.

This takes two forms:

(i) External assistance which means borrowing from foreign countries
under concessional rate of interest;

(ii) Commercial borrowing under which the Indian Government and the
private sector borrow funds from world money market at higher market
rate of interest.

Besides non-resident deposits are another important item in capital

account. These are the deposits made by non-resident Indians (NRI) who
keep their surplus funds with Indian Banks. Another important item in
balance of payments on capital account is foreign investment by foreign
companies in India. There are two types of foreign investment. First is
portfolio investment under which foreign institutional investors (FIIs)
purchase shares (equity) and bonds of Indian companies and
Government.

The second is foreign direct investment (FDI) under which foreign

companies set up plants and factories on their own or in collaboration
with the Indian companies. Still another item in capital account is other
capital flows in which the important source of funds is remittances from
abroad sent by the Indian citizens working in foreign countries. Table 2.5
gives the position of India’s capital account for the years 2007-08 to
2012-13.

Capital inflows in the capital account can be classified into debt creating
and non-debt creating. Foreign investment (both direct and portfolio)
represents non-debt creating capital inflows, whereas external assistance
(i.e. concessional loans taken from abroad), external commercial
borrowing (ECB) and non-resident deposits are debt-creating capital
inflows.
It will be seen from Table 2.5 that during 2007-08, there was net capital
inflow of 43.3 billion US dollars on account of foreign investment (both
direct and portfolio). Table 2.5 gives the position of India’s balance of
payments in capital account for seven years, 2007-08,2008-09,2009-
10,2010- 11, 2011-12 and 2012-13.

When all items of balance of payments on capital account are taken into
account we had a surplus of 107.9 billion US dollars in 2007-08. Taking
into current account deficit of $ 15.7 billion on current account in year
2007-08 there was accretion to our foreign exchange reserves by $ 92.2
billion in 2007-08.

Global financial crisis affected our capital account balance as there was
reversal of capital flows after Sept. 2008 with the result that we used $
20.1 billion of our foreign exchange reserves in 2008-09 resulting in
decrease of our foreign exchange reserves. That is, because we used our
foreign exchange reserves equal to $ 20.1 billion, there was decline in our
foreign exchange reserves by $ 20 billion in 2008-09.

The situation improved in 2009-10 as foreign direct investment (FDI)

and portfolio investment by FIIs picked up. As a result there was net
capital account surplus of $ 53.4 billion in 2009-10 and after meeting the
current account deficit of $ 38 billion there was addition to our foreign
exchange reserves by $ 13.4 billion in 2009-10. In 2010-11 also there was
surplus on capital account of $ 59.7 billion and after meeting current
deficit we added $ 13.1 billion in our foreign exchange reserves in
2010.11.

However, in 2011 -2012 and 2012-13 the situation regarding capital flows
changed significantly and capital flows were not sufficient to meet the
large current account deficit (CAD). Consequently, in 2011-12 withdrawal
from foreign exchange reserves of 12.8 million US dollars was made.
Capital flows are driven by pull factors such as economic fundamentals of
recipient countries and push factors such as policy stance of source
countries.

The capital flows have implications for exchange rate management,

overall macroeconomic and financial stability including liquidity
conditions. Capital account management therefore needs to emphasize
promoting foreign direct investment (FDI) and reducing dependence on
volatile portfolio capital inflows.

This would ensure that to the extent current account defect is bridged
through capital surplus it would be better if it is done through stable and
growth-enhancing foreign direct investment flows. In the present
international financial situation, reserves are the first line of defence
against the volatile capital flows. However, the decline in reserves as a
percentage of GDP is a source of concern.

When all items of balance of payments of capital account are taken into
account we had a surplus of 6.8, 53.9 and 59.7 billion US dollars in 2008-
09, 2009-10 and 2010-11. Small size surplus on capital account of 6.8
billion US dollars in 2008-09 was due to large portfolio capital outflows
by FII, which occurred because of global financial crisis in 2008-09. As a
result of this, capital flows fell short of current account deficit of 27.9
billion US dollars resulting in deficit of 20.1 billion US dollars in 2008-
09.

As a consequence our foreign exchange reserves declined by $ 20.1

billion in 2008-09. However, in 2009-10 and 2010-11, there was enough
capital account surplus so that after meeting current account deficit we
added to our foreign exchange reserves by $ 13.4 and $ 13.1 billion in our
foreign exchange reserves in 2009-10 and 2010-11.

Further, it is important to note that surplus on capital account is mainly

due to foreign investment in India, external commercial borrowing and
NRI deposits which do not belong to us. These investment funds,
especially foreign institutional investment funds and Non-Resident
Deposits, can flow out of India if situation in India is not favourable.

This in fact happened in the year 2008-09 when as a result of global

financial crisis FIIs (Foreign Institutional Investors) sold corporate
shares in the Indian stock market and capital outflow from India took
place on a large scale.

Determinants of Balance of Payments:

It may be further noted that when there is a deficit in the current
account, it has to be financed either by using foreign exchange reserves
with Reserve of Bank, if any, or by capital inflows (in the form of foreign
assurance, commercial borrowing from abroad, non-residential
deposits).

There are several variables which determine the balance of payments

position of a country, viz., national income at home and abroad, the
prices of goods and factors, the supply of money, the rate of interest, etc.
all of which determine exports, imports, and demand and supply of
foreign currency.

At the back of these variables lie the supply factors, production function,
the state of technology, tastes, distribution of income, economic
conditions, the state of expectations, etc. If there is a change in any of
these variables and there are no appropriate changes in other variables,
disequilibrium will be the result.

The main cause of disequilibrium in the balance of payments arises from

imbalance between exports and imports of goods and services that is,
deficit or surplus in balance of payments. When for one reason or
another exports of goods and services of a country are smaller than their
imports, disequilibrium in the balance of payments is the likely result.

Exports may be small due to the lack of exportable surplus which in turn
results from low production or the exports may be small because of the
high costs and prices of exportable goods and severe competition in the
world markets.

Important causes of small exports are the inflation or rising prices in the
country or over-valued exchange rate. When the prices of goods are high
in the country, its exports are discouraged and imports encouraged. If it
is not matched by other items in the balance of payments, disequilibrium
emerges.

Does Balance of Payments Must Always Balance?

It is often said that balance of payments must always balance. What does
it mean? The individuals and business firms of an economy have to pay
for the imports from abroad. If exports are not sufficient to pay for the
imports, then how the balance of payments will be in balance.

For example, the balance of payments on current account of India has

been in deficit for most of the years till 2000 01. Deficit on current
account implies that the residents of a country are spending more on
imports of goods and services than the incomes they are earning from
exports of goods and services.

For the overall balance of payments to be in balance, this deficit in the

current account of the balance of payments must be financed by selling
capital assets of such as shares and bonds of companies or other assets
such as gold or foreign exchange reserves of a country or by borrowing
from abroad.

Both by selling assets or by borrowing from abroad, foreign capital flows

into the country as has been happening in the last several years in India.
These foreign capital inflows are shown in the capital account of the
balance of payments which must be in surplus to finance the deficit in the
current account.

Thus current account + capital account surplus = 0…. (i)

The above fact has an important lesson that must be borne in mind. If a
country has no foreign currency reserves or it has no assets to sell to pay
for the imports and if nobody is willing to lend to it, it will have to cut
down its imports which will reduce productive activity in the economy
and adversely affect economic growth of the country.

Such a crisis situation arose in India in 1991 when our foreign exchange
reserves had fallen to a very low level and no one was willing to lend to us
or give us aid. In fact, due to loss of confidence of foreign investors,
capital outflows were taking place.

Therefore, in 1991 India had to mortgage gold to Bank of England and

Central Bank of Japan to get the necessary foreign exchange to pay for
the needed imports. We had to accept the pre-conditions of IMF for
providing us assistance to tide over the crisis. It is interesting to note this
was done under the guidance of Dr. Manmohan Singh who was then the
Finance Minister.

Capital Flows and Globalisation:

The globalization of the Indian economy has an important consequence
with regard to capital flows into the economy. Suppose India faces given
prices of its imports and a given demand for its exports of goods and
services. Under these circumstances, if domestic rate of interest is higher
as compared to what exists abroad, then given the mobility of capital,
capital will flow into the Indian economy to a very large extent.
This principle can be expressed as follows:
BP = NX (Yd Yf, R) + CF (If – Id) … (ii)
where BP = balance of payments, NX is net exports (i.e. exports-imports
which is also called trade balance, CF stands for surplus in the capital
account of the balance of payments, that is, capital flows.

The above equation reveals that trade balance (NX) is a function of level
of domestic income (Yd) and foreign income (Yf) and real rate of exchange
(R). An increase in the domestic income due to higher industrial growth
or fall in real exchange rate of rupee will adversely affect the trade
balance (NX) by increasing imports. lf– Id in equation (ii) measures net
foreign investment, i.e. net capital inflows.
Further, the above equation shows that higher interest rate in India as
compared to that in the foreign country such as the United States will
cause large capital inflows into India. Such capital inflows actually took
place in India 2009-10 and 2010-11. Due to large capital inflows into the
Indian economy our foreign exchange reserves increase. However, when
there are large capital outflows as occurred during 2008-09, our foreign
exchange reserves decline.

Recent Data Trend:India's current account deficit (CAD) worsened to

USD 16.9 billion (2.5% of GDP) during October-December (Q4 2018)
from a level of USD 13.7 billion (2.1% of GDP) in the corresponding
quarter a year ago. The widening of CAD was on account of higher imports
which resulted in a widening trade deficit. The merchandise trade deficit
rose to USD 49.5 billion in Q4 2018. With the given decline in crude oil
prices in the global market, we can expect trade deficit to slightly reduce in
the last quarter of the current year. On account of net sales in the equity
market, the portfolio investment recorded a net outflow of USD 2.1 billion
in Q4 2018, as compared with an inflow of USD 5.3 billion in Q4 2017.
Despite the widening CAD on year-on-year (y-o-y) basis, the Q4 2018
witnessed an accretion of USD 9.4 billion to the foreign exchange reserves
(on a BoP basis) as capital account have eased appreciably lately. The
capital and financial account surplus rose to USD 18 billion in Q4 2018
from USD 12.6 billion in Q4 2017, supported by stronger FDI and portfolio
investment inflows worth USD 10.4 billion.
On a cumulative basis, during April-December 2018, the CAD increased to
2.6% of GDP from 1.8% of GDP during April-December 2017, led by
higher trade deficit. India's trade deficit increased to USD 145.3 billion in
April-December 2018 from USD 118.4 billion in the same period last year.
Brief Overview
The Balance of Payments (BoP) records all economic transactions between
residents of a country and the rest of the world. The BoP account consists
of Current account, Capital account, and Financial Account.
The current account includes flows of goods, services, primary income, and
secondary income between residents and non-residents and thus constitutes
an important segment of BoP. The primary income account reflects the
amounts payable and receivable in return for providing temporary use of
labour, financial resources, or non-produced non-financial assets (natural
resources). The secondary income account shows redistribution of income
between resident and non-residents, i.e when resources for current purposes
are provided without economic value being exchanged in return (transfers).
On the other hand, the capital account comprises credit and debit
transactions under non-produced non-financial assets and capital transfers
between residents and non-residents. Thus, acquisitions and disposals of
non-produced non-financial assets, such as land sold to embassies and sales
of leases and licenses, as well as transfers which are capital in nature, are
recorded under this account.
The financial account reflects net acquisition and disposal of financial
assets and liabilities during a period. Further, it shows how the net lending
to or borrowing from the rest of the world has occurred. Conversely, it
shows how the current account surplus is used or the current account deficit
is financed.
The Reserve Bank of India (RBI) has been compiling and publishing
Balance of Payments (BoP) data for India since 1948. Since then, several
developments have taken place both globally and domestically.
Considering these developments and to bring out a comprehensive Balance
of Payments Manual documenting current practices, procedures of
compilation, presentation, coverage and sources of data for India’s balance
of payments and assess them in relation to international best
practices, India has shifted from BPM 5,1993 manual to BPM6,2009
method of accounting and classifying the data.
Methods of Exchange Controls | International
Economics
The methods of exchange control may be classified broadly into two
groups: 1. Direct Methods 2. Indirect Methods.

1. Direct Methods:
The direct methods of exchange control are adopted by the central bank
with the object of restricting the use and the quantity of foreign
exchange. These include intervention, exchange restriction, exchange
clearing agreements and payments agreements.

They are briefly described as under:

(i) Intervention:
The central bank or government of a country may intervene in the foreign
exchange market with a view to raise or lower the exchange value of
home currency relative to foreign currency through the sale or purchase
of the former. It is termed as pegging. The sale of home currency in the
foreign exchange market is made to peg the rate of exchange at a lower
than the free market rate of exchange. The buying of the home currency,
on the other hand, permits the pegging of rate of exchange at a level
higher than the free market rate.

It means the central banking or government intervention in the foreign

exchange market through sale of home currency takes place, when the
excess demand for the home currency is likely to cause its significant
appreciation. In the event of excess demand pressures for the foreign
currency, when the depreciation of home currency is likely to occur, the
intervention will take the form of purchase of home currency in the
foreign exchange market. So intervention can ensure stability of
exchange rate at the officially fixed level.

As regards the effectiveness of intervention, it has certain limitations.

Firstly, the intervention through the sale of foreign currency can be
successful only, if a country has sufficiently large reserves of foreign
currencies.

Secondly, it is easier for a country to sell the home currency and buy the
excess amount of foreign exchange through the use of home currency. It
is greatly constrained in the sale of foreign currency.

Thirdly, the intervention in the foreign exchange market or the pegging

operations should be employed as a temporary expedient and cannot be a
permanent remedy of exchange instability. In this context, Crowther
said, “But it is nevertheless an expensive and hazardous proceeding for
any country that adopts it more than a temporary expedient. We may
conclude that intervention is temporarily, rather than permanently,
possible.”

(ii) Exchange Restrictions:

The exchange restriction is a more severe form of exchange control. The
exchange restrictions include such policies or measures as are directed to
restrict or reduce compulsorily the flow of domestic currency in the
foreign exchange market.

The policy of exchange restriction, according to G. Crowther, is a

compulsory reduction by the government of the supply of its currency
into the market. The essence of this type of control is the acquisition by
the government or the central bank of all foreign exchange earnings and
receipts and their exchange for domestic currency.

The importers and other categories of people can purchase foreign

exchange only from the government or central banking authorities.

The exchange restrictions assume following inter-linked

forms:
(A) Compulsory surrender of all foreign exchange earnings or receipts to
the central bank or government;

(B) Prevention of the exchange of local currency with foreign currencies

without prior permission of government or central bank;

(C) Prescription of all foreign exchange transactions through the central

agency;

(D) Enactment of laws providing for punishment in the event of non--

compliance of foreign exchange regulations.

The prominent variants of exchange restrictions are as

follows:
(a) Blocked Accounts:
Under the system of blocked accounts, the central bank of an importing
country maintains the foreign exchange accounts of the foreign
exporters. The central bank does not permit the creditors to use their
currency holdings in their accounts for a specified period.

That is why these accounts are referred as blocked accounts. The

balances held in these accounts, no doubt, can be utilised by the creditors
in the country where the accounts are blocked. This provides some time
during which a debtor or deficit country can adopt appropriate corrective
actions.

Germany adopted this practice in 1931. England resorted to it during

1939-45 period when large sterling balances, payable to India, got
accumulated on account of large scale imports of goods from the latter
during war period. The payment remained blocked till the termination of
war. Only after 1945, the payments were released in installments at the
convenience of England. The system of blocked accounts has certain
drawbacks.

Firstly, this exchange restriction is clearly unethical and illegal.

Secondly, it leads to corruption and black marketing in foreign exchange.

Thirdly, it hinders the international flow of goods and services and

adversely affects the welfare of the peoples of the concerned countries.

Fourthly, it can have serious strains on political relations between the

creditor and debtor countries and hamper international economic co-
operation.

(b) Multiple Exchange Rates:

Under this system, a country has an elaborate structure of exchange rates
applicable to different categories of imports, exports and capital
transfers. Low exchange rates are maintained in the case of exportable
goods for stimulating their export. In case of imports, low exchange rates
are established in the case of necessaries but prohibitive (or high)
exchange rates are set in the case of luxury goods or harmful products.

(c) Allocation of Exchange According to Priorities:

The exchange restrictions may be practiced by the central bank of a
country, when the foreign exchange is allocated for the import of
different categories of goods and for other purposes according to a
specific order of priorities. For instance, the import of essential items like
food, raw materials, intermediate products, defence materials,
machinery, and technology may be accorded a higher priority compared
with luxury imports. This method of exchange restriction remained in
use in England and several others advanced as well as LDC’s. There are
certain pitfalls in this method.

Firstly, the priorities are often laid down by the government or central
banking officials in an arbitrary way.
Secondly, the procedures related to the processing and sanctioning of
applications for the grant of foreign exchange are quite time-consuming.

Thirdly, this method involves high administrative cost.

Fourthly, this method is often iniquitous as a large proportion of

exchange allocations are cornered by large import houses.

(iii) Exchange Clearing Agreements:

In this system of exchange control, two or more trading countries
establish accounts in their respective countries. The importers of a given
country make payments into that central account in the domestic
currencies. These amounts are paid out to the exporters for the goods
exported by them to each country. The claims and counter-claims upon
foreign exchange related to different countries are adjusted through
appropriate book entries.

Any surplus or deficit after the clearing operations is settled either in

terms of gold or a convertible currency acceptable to the trading
partners. This method greatly simplifies the payment mechanism. This
method is expedient for those countries which do not have sufficient
foreign exchange reserves.

The device of exchange clearing agreement was extensively used by many

a country during the 1930’s. Germany, for instance, entered into clearing
agreements in early 1930’s with such countries as Sweden, Switzerland,
Egypt and Balkan countries.

After Second World War, the sterling area constituted by England and
Commonwealth countries essentially represented a multi-lateral
payments agreement. Another prominent example of multilateral
arrangement was the European Payments Union (EPU) that existed
between 1950 and 1958. Every clearing agreement has a tendency to
restore the BOP equilibrium in an automatic way.

This method of exchange control has certain drawbacks. Firstly, the

settlement of receipts and payments on account of international trade is
made on the basis of some pre-existing exchange rate. The economically
stronger countries, having superior bargaining power enforce a rate of
exchange which is usually disadvantageous for an economically weaker
country. Thus the clearing agreements involve the exploitation of the
latter.
Secondly, the necessity of depositing the foreign exchange receipts from
exports in the central bank account may tend to divert the trade from
normal to abnormal channels.

Thirdly, the exporters may indulge in under-valuation of exports and

accept payments from foreign importers in their currency directly from
them or they may retain unaccounted accounts in foreign countries.

Fourthly, the exchange clearing agreements tend to make settlement

without the transfer of foreign currencies. As there are no free flows of
foreign currencies, these agreements are likely to do away with the
foreign exchange market.

Fifthly, the clearing agreements are also likely to have discouraging effect
upon the volume of international trade.

Sixthly, in the clearing agreements, it is not necessary that the volumes of

exports and imports are in balance. In order to balance the two, the
central banks supply their own currency at a fixed exchange rate to the
other country upto a specified limit. This is called as a swing. The size of
the ‘swing’ can have serious adverse effect upon trade between two or
more countries. A very large ‘swing’ may be clearly wasteful.

On the opposite, if the ‘swing’ is too small, the limit may be reached soon
and the country, faced with the prospect of losing gold, may impose
physical tariff or non-tariff barriers upon trade. Thus there can be a
possibility of trade coming to naught.

Finally, if a country has an excess of exports over imports, more money

will flow out to exporters than what is deposited by importers in the
clearing account. That is likely to have an inflationary impact upon the
domestic economy. In the opposite case of excess of imports over
exports, there is a net reduction in money supply. As a consequence, the
economy is likely to face the deflationary conditions.

(iv) Payments Agreements:

The payments agreement between two countries is a more
comprehensive type of exchange control than the exchange clearing
agreements. It covers not only the payments on account of export and
import of commodities but also the payments due to different types of
services such as shipping, banking, insurance and items like debt
servicing and tourism. It provides a mechanism for the repayment of
external debts.
A part of the payments for imports by the creditor country is retained in
the clearing account for repayment of debts and the remaining amount is
paid out to the exporters of the debtor country. The creditor country
normally does not impose any restriction upon the imports from the
debtor country but the latter can impose restrictions upon the imports
from the former so that it should repay its external obligations through
enlarging its exports.

In 1947, Britain entered into payment agreements with India, Argentina,

Brazil, Ceylon, Egypt and some other countries that were holding sterling
balances over the years of Second World War. These agreements
provided for the maintenance of two sterling accounts in favour of these
countries in England. In the first account, the sterling balances could be
withdrawn by the creditor countries for the current use.

The second account was a blocked sterling account. The provision in

payments agreement was to permit the phased transfer of the sterling
balances from the blocked account to the other to enable the creditor
countries to make free use of them.

The payments agreements have certain shortcomings. Firstly, the terms

of payments agreements generally favour the stronger or creditor
countries. Secondly, the payments agreements can be operational for two
trading countries. Such agreements cannot be possible on a multilateral
basis unless there is intermediation of the international economic
institutions. Thirdly, the payment agreements provide for the use of
balances in the debtor country on the purchase of specified goods and
services only from the debtor country.

Fourthly, no doubt the payment agreements provide some relief to the

weak and developing countries through making provision for increased
exports for making debt payments, yet the debt burden is extended over a
longer period. There is the possibility of an increase in debt servicing. It
is likely that the balance of payments position of the debtor country
remains unfavorable for a long period.

2. Indirect Methods:
Apart from the direct methods of exchange control, countries
sometimes resort to indirect methods which are as follows:
(i) Tarrif and Non-Tarrif Restrictions:
The countries can resort to tariffs, import quotas and other quantitative
restrictions. These measures reduce the volume of imports and the
demand for foreign currencies gets reduced. That brings about an
improvement in the balance of payments situation. The quantitative
restrictions on imports result in appreciation of home currency relative
to the foreign currency.

(ii) Export Subsidies:

When the government follows the policy of subsidizing exports, the home
exporters are induced to enlarge exports. This measure, on the one hand,
can bring about an improvement in the BOP deficit and, on the other, can
raise the external value of home currency.

(iii) Increase in Interest Rates:

The increase in the structure of interest rates in the home country leads
to an inflow of capital from abroad and the prevention of capital outflow.
These changes effect improvement in the BOP situation in addition to
making the foreign exchange rate more favourable.

There is, however, a severe constraint in the form of possible adverse

effect of higher rates of interest upon the home investments that
dissuades the monetary authority from resorting to this measure beyond
a specified limit. In addition, the increase in the structure of interest rate
by the foreign countries can neutralise such a policy.

In evaluating the indirect exchange controls, G. Crowther comments,

“These methods of indirect exchange control, therefore, though they are
by no means negligible, are not merely strong or precise enough
instruments for a government that aspires to bring the exchange rates
under close control.” In order to make the system of exchange control
fully effective and capable of achieving its different objectives, it is
essential that there is a proper integration of direct and indirect methods
of exchange control.

--------------------------------------------------------------------------------------

Methods of Exchange Control

Exchange control is one of the important means of achieving certain national objectives like
an improvement in the balance of payments position, restriction of inessential imports and
conspicuous consumption, facilitation of import of priority items, control of outflow of capital
and maintenance of the external value of the currency. Under the exchange control, the
whole foreign exchange resources of the nation, including those currently occurring to it,
are usually brought directly under the control of the exchange control authority (the Central
Bank, treasury or a specially constituted agency). Dealings and transactions in foreign
exchange are regulated by the exchange control authority. Exporters have to surrender the
foreign exchange earnings in exchange for home currency and the permission of the
exchange control authority have to be obtained for making payments in foreign exchange. It
is generally necessary to implement the overall regulations with a host of detailed
 provisions designed to eliminate evasion. The allocation of foreign exchange is made by
the exchange control authority, on the basis of national priorities.

The various methods of exchange control may be broadly classified into (1) Unilateral
methods and (2) Bilateral/multilateral methods.

Unilateral Methods

Unilateral measures refer to those methods which may be adopted by a country unilaterally
i.e., without any reference to or understanding with other countries. The important unilateral
methods are outlined below.

1. Regulation of Bank Rate: A change in the bank rate is usually followed by changes in all
other rates of interest and this may affect the flow of foreign capital. For example, when the
internal rates of interest rise, foreign capital is attracted to the country. This causes an
increase in the supply of foreign currency and the demand for domestic currency in
the foreign exchange market and results in the appreciation of the external value of the
currency. A lowering of the bank rate is expected to produce the opposite results.
2. Regulation of Foreign Trade: The rate of exchange may be controlled by regulating the
foreign trade of the country. For example, by encouraging exports and discouraging
imports, a country can increase the demand for, in relation to supply, its currency in the
foreign exchange market and thus bring about an increase in the rate of exchange of the
country’s currency.
3. Rationing of Foreign Exchange: By rationing the limited foreign exchange resources, a
country may restrict the influence of the free play of market forces of demand and supply
and thus maintain the exchange rate at a higher level.
4. Exchange Pegging: Exchange pegging refers to the policy of the government of fixing the
exchange rate arbitrarily either below or above the normal market rate. Pegging operations
take the form of buying and selling of the local currency by the central bank of a country in
exchange for the foreign currency in the foreign exchange market, in order to maintain an
exchange rate whether, it is overvalued or undervalued. Thus, pegging may be pegging up
or pegging down. Pegging up means holding fixed overvaluation, i.e., to maintain the
exchange rate at a higher level. Pegging down means holding fixed undervaluation, i.e., to
maintain the exchange rate at a lower (depressed) level. In the case of pegging up, the
central bank shall have to keep itself ready to buy unlimited amount of local currency in
exchange for foreign currencies at a fixed rate, because overvaluation tends to increase the
demand for foreign currencies by creating import surplus. In the case of pegging down, the
central bank or central agency shall have to keep itself ready to sell any amount to local
currency by creating export surplus. Similarly, pegging up involves holding of sufficient
amount of foreign currencies while pegging down involves holding of sufficient amount of
local currency by the central bank. It goes without saying that pegging up, is more difficult
to maintain as it requires huge amounts of foreign currencies which is difficult to obtain. As
such pegging up can be adopted only as a temporary expedient. It should be noted that
intervention by a government in the foreign exchange market has the effect of neutralizing
the forces of demand and supply of foreign exchange. However, it is generally assumed
that government intervention or pegging up and pegging down operations should be used
as temporary expedients to remove fluctuations in the exchange rate.
5. Multiple Exchange Rate: Multiple exchange rates refer to the system of the fixing, by a
country, of the different rates of exchange for the trade or different commodities and/or for
transactions with different countries. The main object of the system is to maximize the
foreign exchange earning of country by increasing exports and reducing imports. The entire
structure of the exchange rate is devised in a manner that makes imports cheaper and
exports more expensive. The multiple exchange rate system has been severely
condemned by the IMF.
6. Exchange Equalization Fund: The main object of the Exchange Equalization Fund, also
known as the Exchange Stabilization Account, is to stabilize the exchange rate of the
national currency through the sale and purchase of foreign currencies. When the demand
for domestic currency exceeds its supply, the fund starts purchasing foreign currency with
the help of its own resources. This results in an increase in the demand for foreign currency
and increases the supply of the national currency. The tendency of the rate of exchange of
the national currency. to rise can thus be checked. When the supply of the national
currency exceeds demand and the exchange rate tends to fall, the Fund. sells the foreign
currencies and this increases the supply of foreign currencies and arrests the tendency of
the exchange rate of the domestic currency to fall. This sort of an operation may be
resorted to eliminate short term fluctuations.
7. Blocked Accounts: Blocked accounts refer to bank deposits, securities and other assets
held by foreigners in a country which denies them conversion of these into their home
currency. Blocked accounts, thus, cannot be converted into the creditor country’s currency.
Under the blocked accounts scheme, all those who have to make payments to any foreign
country will have to make them not to the foreign creditor directly but to the central bank of
the country which will keep the amount in the name of the foreign creditor. This amount will
not be available to the foreigners in their own currency, but can be used by them for
purchase in the controlling country.

Bilateral/Multilateral Methods

The important bilateral/multilateral methods are the following:

1. Private Compensation Agreement: Under this method, which closely resembles barter, a
firm in one country is required to equalize its exports to the other country with its imports
from that country so that there will be neither a surplus nor a deficit.
2. Clearing Agreement: Normally, importers have to make payments in foreign currency and
while exporters are paid in foreign currency. Under the clearing agreement, however,
importers make payments in domestic currency to the clearing account and exporters
obtain payments in domestic currency from the clearing fund. Thus, under the clearing
agreement, the importer does not directly pay the exporter and hence, the need fore foreign
exchange does not arise, except for settling the net. balance between the two countries.
3. Standstill Agreement: The standstill agreement seeks to provide debtor country some
time to adjust their position by preventing the movement of capital out 01 the county
through a moratorium on the outstanding short-term foreign debts
4. Payments Agreement: Under the payments agreement, concluded between a debtor
country and a creditor country, provision is made for the repayment of the principal and
interest by the debtor country to the creditor country. The creditor country refrains from
imposing restrictions on the imports from the debtor country in order to enable the debtor to
increase its exports to the creditor. On the other hand, the debtor country takes necessary
measures to encourage exports to and discourage imports from the creditor country.
Customs Union: Dynamic Effects and Theory |
International Economics
In this article we will discuss about:- 1. Dynamic Effects of Customs
Union 2. Theory of Customs Union as the Theory of Second Best 3. Intra-
Industry Trade and Customs Union.

Dynamic Effects of Customs Union:

The static effects of customs union are- (i) trade- creation and (ii) trade-
diversion. The static effects are basically concerned with reallocation of
production and consumption. In fact the formation of the customs union
initiates a process of structural and technical readjustments, on the one
hand, amongst the member countries and, on the other, among the non-
member countries.
Such long-lasting dynamic effects of customs union have been greatly
emphasised by the writers like T. Scitovsky, B. Belassa and W.M. Corden.
The dynamic effects of customs union are as follows:
1. Increased Competition:
The most significant dynamic effect of customs union is the increase in
intensity of competition within the union. Earlier in the sheltered
markets, the monopolistic and oligopolistic industries had become
sluggish and complacent. After the formation of customs union, as they
are exposed to competition from rival firms within the union, they have
to operate in the most efficient way or face the risk of elimination.
All the firms, earlier operating below their optimum productive capacity,
make efforts to expand production in order to cater to the demand from
an expanded market and to minimise their costs. Competition also
stimulates the managerial efficiency and induces the industries to utilize
new technology.
The customs union must take care that collusion and market-sharing
arrangements, which had earlier restricted competition at the national
level, should not restrict competition at the union level. In this direction,
the member countries should enforce antitrust legislation throughout the
customs union.
2. Economies of Scale:
When a customs union is formed, expansion in the size of market,
increased competition, increased specialisation and consequent
enlargement of plant size lead to the emergence of internal and external
economies of scale. This is evident from the experience of the countries of
European Community (EC). The formation of EC resulted in economies
of scale due to reduction in the range of differentiated products, increase
in production run, pooling of skilled labour, capital resources, research
and management.
3. Stimulus to Investment:
The expansion of market and more intensified competition stimulates
investment activity. The need for introducing new techniques and
accelerated depreciation of the existing plants and equipment step up
greatly the rate of investment. In addition, there is also strong stimulus
to foreign investment. Many non-member countries set up their plants in
the territory of union members so that their products can evade the tariff
barriers.
Such industrial units are called as tariff factories. The massive United
States investments in Europe after 1955 were probably on account of the
American desire of not to be excluded from the rapidly expanding market
of EC.
4. Movement of Productive Factors:
After the formation of customs union, or more particularly, the common
market, there is free movement of labour, capital and enterprise within
the entire region of the common market. This ensures the optimal
utilization of resources, increase in factor productivity and consequent
rise in the growth rate of the economies of all the countries in the union.
5. Technological Advance:
As a customs union is formed, expansion in the size of market, greater
competition, need for increasing the scale of production and achieving
higher factor productivity, make the firms and industries develop very
strong urge to imitate, to innovate and to make commercial application
of technical, scientific and managerial innovations.
There is strong stimulus to research for making improvements in the
production techniques, processes of production and quality of products.
The intense technological developments tend to push up the rate of
economic growth.
6. Improvements in the Terms of Trade:
The formation of the customs union results in raising of external tariffs
against the outside world and consequent reduction in imports from
abroad. This tends to raise the bargaining power of the union members
against the rest-of-the-world. The improvement in the terms of trade
brings about also an improvement in the balance of payments position of
the member countries.
7. Reduction of Risk and Uncertainty:
The foreign transactions often involve high degree of risk. The
complexity of trade regulations, unilateral changes by countries in the
tariff and non-tariff trade restraints and foreign exchange regulations
create much uncertainty. The economic integration reduces to a
significant extent, risk and uncertainty particularly in respect of the
inter-member transactions.
It is on account of these dynamic benefits that the West European
countries and the countries of certain other regions deemed it
appropriate to organise themselves into some form of economic
integration. The recent empirical studies seem to indicate that the
dynamic gains of customs unions are five to six times larger than the
static gains.
Theory of Customs Union as the Theory of Second Best:
The maximisation of welfare can be possible only under the conditions of
free international trade. The Pareto-optimality conditions can be valid
only under perfect competition and unrestricted international trade. If a
customs union is formed, there is a violation of Pareto-optimality
conditions.
In a customs union, there is no doubt elimination of tariff restrictions
and it is a movement towards freer trade, yet there may be certain
imperfections in the expanded market of customs union on account of
the existence of oligopolies and product differentiation.
The rigidities exist on account of diverse monetary and fiscal policies,
unless integration assumes the most advanced form of economic union.
In addition, the maintenance of high external tariffs amounts to
sheltering of inefficient industries within the union. It means the process
of production, despite integration, is not likely to become ideal. The
formation of the customs union does not necessarily maximise welfare.
In certain situations, it may result in a net loss in welfare. Therefore, the
customs union is not consistent with Pareto-optimality. It is rather
concerned with Pareto-non-optimal or sub-optimal trade situation.
The theory of customs union is a half-way house between free trade and
protection. From this consideration, the theory of customs union can be
treated as a theory of the second best.
Intra-Industry Trade and Customs Union:
A number of empirical studies, related to intra- industry trade have
indicated that a considerable part of trade among the members of
European Community (EC) is of the nature of intra-industry trade. No
doubt, many models of intra-industry trade have been developed but a
few attempts have been made to relate it to the customs union.
However, a simple model, based on Neo-Chamberlinian model of intra-
industry was developed by W. Ethier and H. Horn in 1984. This model
attempted to explain the possibility of trade creation gains from intra-
industry trade due to integration.
In this model, it is assumed that two countries A and B, before forming
customs union produce homogeneous commodity, food and a
differentiated product, say machinery. The different variants of
manufactured product (machinery) are imperfect substitutes for one
another. The production in their case is governed by increasing returns to
scale. Both countries A and B export their own varieties of manufactured
products to each other as well as to the rest-of-the-world (W).
The rest- of-the-world produces food only. The production of food is
governed by constant returns to scale. Countries A and B import food
from rest of the world. The two countries before forming the customs
unions were having the same tariff on the import of food and
manufactured products. There was no restriction by the rest-of-the-world
on the import of manufactures.
After the formation of customs union by A and B, the existing tariff on
the import of food becomes the common external tariff. Since member
countries of customs union did not import manufactures earlier from the
rest-of-the-world and they exported varieties of manufactured product
(machinery) to each other, there would be no trade diversion after the
formation of customs union.
The trade creation effect, however, would be present. The two countries
will be able to secure gain due to trade creation as consumers of each
country will have duty free access to a greater variety of goods. The
consumption of larger variety of goods will definitely increase the level of
welfare.
Investment Multiplier REVIEWED BY WILL KENTON Updated Aug 31, 2018
What is an Investment Multiplier
An investment multiplier refers to the concept that any increase in public or private
investment spending has a more than proportionate positive impact on aggregate
income and the general economy. The multiplier attempts to quantify the additional
effects of a policy beyond those immediately measurable. The larger an investment's
multiplier, the more efficient it is at creating and distributing wealth throughout an
economy.

BREAKING DOWN Investment Multiplier

An investment multiplier tries to determine the financial impact of a public or private
project. For instance, extra government spending on roads can increase the income of
construction workers, as well as the income of materials suppliers. These people may
spend the extra income in the retail, consumer goods, or service industries, also
boosting the income of workers there. Furthermore, individuals and businesses stand
to gain from access to better roads.

Calculating an Investment Multiplier

An investment multiplier's value is a function of several factors, including
the marginal propensity to consume (MPC) and the marginal propensity to
save (MPS) of the people whose payment for labor constitutes the investment's
expenditures, such as the construction workers, engineers and material suppliers in the
previous example.

If the marginal propensity to consume of a project's workers is 0.75, then 75% of the
workers' income is spent on goods and services that produce income for another
individual or business, and 25% of their income is withdrawn from circulation by
means of savings, taxation or expenditures on foreign goods and services. This same
project has an investment multiplier of 4, which means that for every $1 spent
investing in the project, another $4 of income is generated. The investment multiplier
is calculated as 1/(1-MPC), or 1/(1-0.75), in the example.

Economic Applications of Investment Multipliers

There are many types of people with a vested interest in quantifying the investment
multiplier of a particular project, including government officials, investors, financial
analysts, real estate developers and neighborhood groups. Total output and job
creation tend to be highest when dealing with commercial and real estate investments
because investment costs are overshadowed by a wave of economic activity.

Business cycle analysts, central bankers, and policy planners study investment
multipliers on an aggregate level to observe the general flow of wealth in an economy,
and to better understand certain variables such as employment, prices and the velocity
of the money supply. The concept of a multiplier effect is applied in many other areas,
such as unemployment benefits and tax policy.
National Income and The Foreign
Trade Multiplier
National Income and The Foreign Trade Multiplier!
The Import Function:
In an open economy consumers of a country also spend some income on
imported goods.

The imports of a country depend on its level of income. The higher the level of
income, the prices of imported goods and tastes of consumers remaining the
same, the greater will be its imports.

The relationship between imports and level of income of a country is called

the import function and is written as:
M = f(Y)

where M stands for imports and Y for income of a country.

We have shown the import function in Fig. 24.1 where on the X-axis the level of
national income and on the Y-axis imports of a country are measured. It will be
seen that even at zero national income some imports are undertaken by
exporting some capital accumulated in the past or by borrowing from abroad.

There are two concepts of propensity to import which should be understood.

First, average propensity to import is defined as the proportion or percentage of
national income spent on imports, that is, it is rupee value of imports divided by
national income or M/Y.

Large countries such as the U.S.A., Russia and India have low average
propensity to import and small countries such as Great Britain and Holland have
high average propensity to import. The average propensity to import in India is
between 0.02 and 0.03.
More important concept is the marginal propensity to import. The marginal
propensity to import measures the change in import as a result of increase in
national incomes and is algebraically expressed as ΔM/ΔY where ΔM is the
change in value of imports and ΔY is the increase in national income. If imports
increase by Rs. 3 when national income rises by Rs. 100, the marginal
propensity to import (ΔM/ΔI) will be equal to 3/100 = 0.03 or 3 per cent. If
increase in income by Rs. 100 leads to the increase in imports by Rs. 10, the
marginal propensity to imports is 10/100 = 0.1 or 10 per cent.

The Foreign Trade Multiplier in an Open Economy:

In a closed economy equilibrium level of national income is determined at the
level where intended saving equals intended investment (S = I). Saving
represents leakage or withdrawal of some money from the income flow, while
investment is the injection of some money into the income stream.

The level of national income is in equilibrium (that is, circular flow of income is
constant) when leakage from the income stream in the form of savings is equal
to the injection of investment expenditure. In an open economy, the role of
foreign trade, that is, exports and imports of a country are also to be considered.
Imports by consumers of a country represent the expenditure on imported goods
by the residents of the country and leads to the leakage of some income from
domestic economy.

Therefore, in addition to saving, imports are other form of leakage that occur in
an open economy. On the other hand, exports represent expenditure by the
people of foreign countries on the goods produced in the domestic economy and
are, like domestic investment, injection into the income stream of an open
economy.

Therefore, equilibrium level of national income in an open economy is

determined at the level at which total leakage, that is, savings plus imports (S +
M) equal total injection, that is, domestic investment plus exports (I + X) into
the income stream.

Thus, in an open economy, national income is in equilibrium at the level at

which

S+M=I+X

When a change in any of the above four variables occurs, then the change on the
left side of the above equation must equal the change on the right side if the new
equilibrium is to be achieved.

Hence
ΔS + ΔM = ΔI + ΔX …(1)

Now, change in saving, ΔS = s. ΔY

Where s = marginal propensity to save and

ΔY= change in national income.

Likewise, change in imports, ΔM = m. ΔY

where m = marginal propensity to import.

Thus, foreign trade multiplier is equal to the reciprocal of marginal propensity to

save (s) plus marginal propensity to import (m). It is evident that smaller the
leaks, that is, smaller the values of marginal propensity to save (s) and marginal
propensity to import (m) the greater the value of foreign trade multiplier. Let us
given an example. If s = 0.2 and m = 0.2, then

Graphic Representation of Foreign Trade Multiplier:

The foreign trade multiplier has been graphically illustrated in Fig. 24.2 where S
+ M is the saving plus import function curve and X0 is the export curve which is
constant as it has been assumed to be an autonomous variable, that is,
independent of the level of income. To simplify our analysis we assume that
there is no investment, equilibrium level of national income will therefore be
determined by consumption (saving) and exports.
Initially, the economy is in equilibrium at level of income Y0 where S + M=X0,
investment being zero. Suppose there is autonomous increase in exports so that
export curve shifts upward from X0 to X1. It will be seen from Fig. 24.2 that
equilibrium income increases to Y1.

Thus, increase in exports (ΔX) has led to the increase in income (ΔY) equal to
Y1 – Y0 which is much greater than change in exports (ΔX). The expression
ΔY/ΔX represents the foreign trade multiplier whose value depends on the slope
of saving-import function curve S+ M which is equal to the reciprocal of the
sum of marginal propensity to save and marginal propensity to import (1/s + m).
How the Foreign Trade Multiplier Works?
The foreign trade multiplier works in the same way as Keynes’ investment
multiplier. When there is increase in exports, it will cause the increase in income
of the exporters and those employed in the export industries. They will save
some of the increase in their incomes and will spend a good part of the increases
in their incomes on consumer goods, both domestic and imported ones.

While savings do not generate further income and represent leakage from the
income stream, expenditure on imports leads to the increase in the incomes of
the foreign countries from which goods are imported. Thus expenditure on
imports also represents a leakage from the income stream as far as domestic
economy is concerned.

But the increased expenditure on domestic goods as a result of increase in

exports will go on increasing incomes in various successive rounds of spending
till the multiplier fully works itself out.
It may be noted that increase in exports of a country can occur due to several
reasons. There may be change in tastes or demand of the people of foreign
countries for goods of a country. To begin with, the exporters may meet the
demand for exported goods by selling their inventories and enjoy higher
incomes.

But in the next periods, they will make efforts to increase the production of
exported goods and employ more workers. This will generate new income and
employment in the export industries. But the working of multiplier does not stop
here.

Those employed in export industries will spend a good part of their increased
incomes on goods produced by other industries and in this way increases in
income, production and employment will spread in the whole of the domestic
economy.

The Foreign Trade Multiplier: With both Exports and Domestic

Investment:
In our foregoing analysis we have explained the multiplier effect of autonomous
increase in exports assuming that there is no domestic investment. We will now
further elaborate the foreign trade multiplier by considering both exports and
domestic investment.

In an open economy when there is positive investment the level of equilibrium

in national income is reached when sum of domestic investment and net exports
equals saving.

Thus, in an open economy the condition for the equilibrium level of

national income is:
Id + Xn = S …(1)
where Id is domestic investment, Xn is net exports and S is the saving
Net exports (Xn) is the net of exports over imports, that is, Xn = X – M
Substituting X – M for Xn in equation (1) we get
Id + (X – M) = S
or Id + X = S + M
In the case when there is positive domestic investment the determination of the
equilibrium level of national income is graphically shown in Fig. 24.3. The
curve Id represents autonomous domestic investment which remains constant. S
is the saving function curve showing that saving is the increasing function of
income.
Over the domestic investment curve (Id) we have added the exports (X) of the
economy to get Id + X curve. To the saving function curve we have added the
import function curve to obtain the aggregate of saving and import functions
curve (S + M).
It will be observed from Fig. 24.3. That Id + X equals S+M at point E and thus
the equilibrium level of national income Y0 is determined. Note that at Y0 level
of income saving (S) and domestic investment (Id) are also equal. Thus, at
equilibrium income Y0:
Id + X = S + M
and Id = S
Therefore, at Y0 equilibrium income:
X=M

The equality of exports (X) with imports (M) implies that there is equilibrium in
the balance on the current account. However, it is important to note that it is not
necessary that at equilibrium level of national income exports (X) equal imports
(M).

This equilibrium in the current account balance along with equilibrium of saving
and domestic investment occurs only when exports are equal to imports at the
equilibrium level of income determined by the equality of saving and domestic
investment.

In Fig. 24.3. at equilibrium income Y0 at which saving equals domestic

investment, imports are equal to DE. If exports happen to be equal to DE, the
equilibrium in the current account balance will also occur. However, this is not
necessary because exports may be greater or less than the imports DE.
Suppose autonomous exports increase so that the investment – exports curve
shifts above to Id + X1 as shown in Figure 24.4. This new Id + X1curve intersects
S + M curve at point H and as a result equilibrium national income Y1 is
determined. It will be seen from Fig. 24.4 that at national income Y1 the volume
of exports is LH which exceeds the imports CH by LC amount.
Note that LC is the amount by which saving exceeds domestic investment. It is
this excess of saving over domestic investment that maintain the equation ld + X
= S + M despite exports (X) being not equal to imports (M). Thus, in this case
there is surplus in the balance of payments on current account.

The opposite case can also occur when exports fall below ED. If the exports fall
and the investment-export curve shifts to ld + X2 (Fig. 24.5), the new equilibrium
is reached at income level Y2 at which Id+X2= S + M. In this equilibrium
situation imports are equal to VT which exceeds exports (X2) which are equal to
KT.
Thus, though the open economy is in equilibrium as ld + X2 = S + M at income
level Y2, there exists import surplus or deficit in current account balance which
again implies that there is disequilibrium in the balance of payment on the
current count.
However, in this case of import surplus (i.e. deficit in current account balance),
domestic investment must exceed domestic saving by an equal amount so as to
maintain the equality of Id + X with S + M. This is possible only if a country
borrows from abroad to keep investment greater than domestic savings.
The above analysis shows that while the open economy as a whole may be in
equilibrium, it is not necessary that balance of payment (on current account) will
also be in equilibrium.

Increase in Imports: The Reverse Working of Foreign Trade Multiplier:

Whereas increase in exports has an expansionary effect on national income, the
increase in imports will have opposite effect on national income. Imports will
bring about contraction in national income. Further, the effect of increase in
imports on national income will not be equal to the increase in imports but will
have a multiplier effect in reducing national income.

There can be several reasons for the increase in imports of a country. An

important reason for the increase in imports is the change in tastes or
preferences of the people. The people of a country may have started preferring
the imported goods as compared to Swadeshi (home produced) goods.

The reduction in import duties on the imports and thus making them cheaper
may be another reason for the increase in imports a country. The contractionary
effect of increase in imports on the income and employment in a country is
illustrated in Fig. 24.6. To simplify our analysis we have assumed that there are
no net savings and investment.

In this Fig. 24.6 the export curve is a horizontal straight line since exports are
assumed to be autonomous of changes in national income. The curve M
represents the import function curve which slopes upward showing that it
changes with national income.

The two curves X and M intersect at point E and determine Y0equilibrium level
of national income. Now suppose that there is increase in imports (ΔM = ET),
say due to the change in preferences for foreign goods, and as a result import
function curve shifts above to the position M1, the export curve X remaining un-
changed.
It will seen from Fig. 24.6 that new import function curve M1 and export curve
X intersect at point E1 and as result the equilibrium level of income falls to Y1.
Note that reduction in income is greater than the increase in imports; ΔY is
much greater than ΔM. This is due to the working of foreign trade multiplier
which in the present case works to reduce income.
When the consumers buy more foreign goods and less domestically produced
goods, the demand for domestically produced goods decreases which result in
fall in incomes and employment of those engaged in the domestic industries.
These reduced incomes further reduce the expenditure on the purchase of other
home-produced goods and so on. The reverse process of contraction of income,
production and employment goes on till the multiplier fully works itself out.

It is important to note that initial attempt to increase imports has not finally
resulted in any increase in imports. Imports Y0E at the initial equilibrium income
Y0 are equal to imports Y1E1 in the new equilibrium at the much lower level of
income. This is another paradox which is described as import paradox.
What has actually happened is that the increase in imports and consequent
upward shift in the import function leads to a large contraction in income
through the reverse working of foreign trade multiplier so that in the new
equilibrium at a much lower income, less is imported. This is generally referred
to as income effect.