“Domestic trade is among us, international is between us and them.”
Unit 9
External Sector Dynamics
Introduction
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The scope of managerial economics is not limited to
internal trade. Business decision is in a number of ways
affected by the competition and prospectus of sale in
foreign market. A firm may be producing only for
domestic market but it might be using imported raw
materials and intermediate goods. Fluctuation in prices
of imported raw materials affects the cost of production.
Moreover, a firm may have to compete with foreign
goods in the domestic market. Thus, foreign trade and
foreign trade policies do affect the firms directly or
indirectly and also competition in domestic market.
Business managers, therefore, must have knowledge of
the theory and practice of international trade.
INTER-REGIONAL VS.
INTERNATIONAL TRADE
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Interregional trade refers to trade between regions within a
country. It is what Ohlin calls inter-local trade. Thus interregional
trade is domestic or internal trade. Interregional trade on the
other hand, is trade between two nations or countries. A
controversy has been going on among economists whether any
difference between interregional or domestic trade and
international trade is.
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The classical economists held that there were certain
fundamental differences between interregional trade and
international trade. Accordingly, they propounded a separate
theory of international trade which is known as the theory of
comparative costs. But modern economists like Bertil Ohlin and
Haberler contest this view and opine that the differences
between international and international trade are of degree
rather than of kind.
JUSTIFICATION FOR
INTERNATIONAL TRADE
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Factor Immobility
Differences in Natural Resources
Geographical and Climatic Differences
Different Markets
Different Currencies
Change in Currency Value
Problem of Balance of Payments
Different political Groups
Different National Policies
CLASSICAL THEORY OF
INTERNATIONAL TRADE
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Adam Smith’s Theory
In international trade, a country exports that
commodity which is cheaper at home than abroad
and vice versa. Thus, differences in the relative
prices of goods between different countries is the
basis if international trade.
Absolute Cost Advantage
Adam Smith argued for free trade on the basis of
advantages of division of labour. Free trade makes
possible a greater degree of specialisation of labour.
It arguments the gains from territorial division of
labour.
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BALANCE OF PAYMENTS
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The balance of payments of a country is systematic
record of all its economic transactions with the
outside world in a given year. It is a statistical
record of the character and dimensions of the
country’s economic relationship with the rest of the
world.
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According to Bo Sodersten, “balance of payments
is merely a way of listing receipts and payment in
international transactions for a country.”
It shows the country’s trading position, changes in
its net position as foreign lender or borrower and
changes in its official reserve holding.”
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Methods of Removal of Disequilibrium
1. Change in Price-Specie-Flow
Mechanism
2. Change in Foreign Exchange Rate
(Devaluation)
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Rise in Foreign Exchange Rates.
Foreign Demand and Supply
3. Change in Price
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Effect of Price Change.
Consequence of Devaluation
4. Change in Income (Income Effect)
5. Direct Controls.
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Physical Controls
Financial Controls
Inter-relation between National Income
and Balance of Payments.
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A country’s national income and balance of payments are
intimately interrelated. Changes in the one cause changes in
the other. National income is the total domestic production of
final goods and services, broadly classified into consumption
and investment or capital goods, during ant given period of time
which is ordinarily taken as one year. In money terms, it is the
aggregate money expenditure incurred on the production of
domestically produced goods and services.
Exports. Exports are similar to domestic investment outlay in
affecting the national income since each one of these two is like
an injection into the aggregate income expenditure flow
expanding the stream of aggregate income generated by the
purchase of goods and services.
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Foreign Exchange Rate and Foreign Exchange
Market
The market in which currencies of various countries are exchanged, traded
or converted is called foreign exchange market.
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Floating (Flexible) and Fixed Exchange Rate
System
Since exchange rate is a price, its determination can be explained through
demand for and supply of currencies. Suppose we consider the
transactions between two countries, India and USA.
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Appreciation and Depreciation of Currencies
Let us consider the exchange rate of rupee for dollar. Appreciation of a
currency is the increase in its value in terms of another foreign currency.
Thus, if the value of a rupee in terms of US dollar increases from Rs.45.50
to Rs. 44 to a dollar, Indian rupee is said to appreciate. This indicates
strengthening of the Indian rupee. Note that when Indian rupee in dollar
terms appreciates, the dollar would depreciate. On the other hand, if the
value of Indian rupee in terms of US dollars falls, say from Rs. 45.5 to Rs.
46 to a dollar, the Indian rupee is said to depreciate which shows the
weakening of Indian rupee. Thus, under a flexible exchange system, the
exchange value of a currency frequently appreciates or depreciates
depending upon the demand for and supply of a currency.
DETERMINATION OF EXCHANGE
RATE
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Demand for Foreign Exchange (US Dollars)
The demand for dollars by the Indians arises due to the
following factors:
1. The Indian individuals, firms or Government who
import goods from the USA into India.
2. The Indians traveling and studying in the USA would
require dollars to meet their traveling and education
expenses.
3. The Indians who want to invest in equity shares and
bonds of the US companies and other financial
instruments.
4. The Indian firms who want to invest directly in
building factories, sales facilities, shops in the USA.