Assignment Code: MEC-007/AST/2021-22

Course Code: MEC-007

Assignment Name: International Trade and Finance

Year: 2021-2022 (July 2021 and January 2022)

Verification Status: Verified by Professor

Note: Answer all the questions. While questions in Section A carry 20 marks each (to be answered in about 500 words each) those in Section B carry 12 marks each (to be answered in about 300 words each). In the case of numerical questions word limits do not apply.

SECTION A

1) Critically discuss the Ricardian theory of Comparative Advantage. How is it different from Adam Smith’s theory of Absolute Advantage?

Ans) It's worth noting that David Ricardo never questioned the obviousness of profits from trade under Adam Smith's paradigm of absolute advantage. However, Ricardo's contribution was to demonstrate how two countries can benefit from trade even if one had an absolute edge over the other in the production of all things. The question therefore becomes whether, in a case where nation X produces all items at a lower labour cost than country Y, both countries X and Y would benefit from trade advantages.

To grasp this, we might look at the model that Ricardo developed to "propose the theory of comparative advantage."

Ricardo used England and Portugal as examples to illustrate his point. Wine and fabric were the two products produced by both countries. Portugal was thought to use fewer labour units in the production of both fabric and wine. Table 1.1's first two columns depict the cost circumstances in the two countries. Portugal has an absolute advantage in the production of both wine and fabric since the number of hours of labour required for each unit of the two items in Portugal is fewer than in England.

The obvious question is whether trade would benefit both countries. In fact, if the principles of opportunity costs represented in comparative advantages are recognised at this time, both England and Portugal would benefit from trade.

The quantity of another good, namely B, that must be sacrificed in order to produce an additional unit of A is known as the opportunity cost of a good A. The opportunity costs of producing wine and fabric in England and Portugal are lower than each other, as shown in Table 1.1, so England should make and export cloth to Portugal, while Portugal should produce and export wine to the former.

Let us go over it in more detail. Portugal has the lower opportunity cost in wine production (0.89 versus 1.2 in England), but England has the lower opportunity cost in fabric production (0.83 as compared to Portugal 1.12). As a result, Portugal has a comparative advantage in wine production and England has a comparative advantage in fabric manufacture, and both countries should sell the good in which they have a comparative advantage to the other.

This leads us to the term "comparative advantage." If the opportunity cost of manufacturing a good is cheaper at home than in the other country, a country has a comparative advantage in producing that good. It is important to note that technological variations cause the difference in opportunity costs between two countries when producing the same good or the presence of comparative advantage in one country vs another.

Adam Smith claimed that countries can benefit from international trade based on absolute advantage considerations. The pure theory of international trade is built on this foundation.

A simple example can be used to teach the principle of absolute advantage. Assume that two goods, A and B, may be produced solely by labour. In nation A, one unit of good A requires 100 labour units, but in country Y, one unit of good A requires 200 labour units. In nation X, it takes 200 labour units to produce one unit of good B, but only 100 labour units in country Y: To put it another way, country X is more efficient at manufacturing good A than country Y since it requires less labour per unit of output: Country Y, by the same logic, is more efficient in producing good B. Then it's argued that country X has an absolute advantage in generating good A, while country Y has an absolute advantage in creating good B.

Country Y can now profit by producing one unit of B using 100 labour units and exporting it to country X in exchange for one unit of A. In consequence, country Y has employed 100 labour units to indirectly obtain one unit of A, rather than directly producing 0.5 unit of A with the same labour. Country X, on the other hand, must have used 100 units of labour to create the unit of A for export in return for one unit of B. However, if it had attempted to manufacture one unit of B on its own, it would have needed 200 units of labour. As a result, it is possible to deduce that via trading, both countries would benefit from having more of both items.

The example above clearly indicates that if two countries have an absolute superiority in producing distinct items, they can benefit from international commerce. Gains from international trade of products, on the other hand, do not have to be limited to cases of absolute benefit. Ricardo later demonstrated how trade gains can be obtained even in instances of comparative advantage, which became known as the theory of comparative advantage.

2) Explain the various concepts of terms of trade. Critically examine the behaviour of terms of trade as explained by Prebisch.

Ans) The terms of trade (TOT) is the ratio of export prices to import prices and is defined as the relative price of exports in terms of imports. It can be thought of as the amount of import products a country can buy for each unit of export goods.

An improvement in a country's terms of trade helps it since it can buy more imports for the same amount of exports. The exchange rate can alter the terms of commerce because a rise in the value of a country's currency decreases the domestic prices of its imports while having no effect on the prices of the commodities it exports.

Prebisch resurrected the expected evolution of the 'IT, a property of classical analysis, in a development setting. In traditional economics, scarcity of land would raise primary prices and enhance the terms of trade for primary products. Further industrial investment would be unprofitable as a result, and economic growth would come to a halt, bringing the economy to a standstill. This line of thinking has been taken by numerous environmentalists in recent years, beginning with the Club of Rome study.

Prebisch stated that developing countries could not pursue a development strategy based on agriculture sector expansion and export of the increased output. Because developing countries lack the domestic capacity to create capital goods, any attempt to increase an economy's growth rate would necessitate a higher investment ratio and larger capital goods imports. However, because the terms of trade would fall as more agricultural items were exported, export earnings would only expand slowly. As a result, export profits would be insufficient to finance capital goods imports, resulting in BOP issues, and attempts to increase the growth rate would be futile.

Prebisch conducted a detailed statistical study to support his claim that developing country trade terms were deteriorating. He couldn't find data on developing country terms of trade, so he estimated the TT df for the United Kingdom. Because the UK was primarily a manufacturer exporter and a consumer importer, Prebisch concluded that the UK's TT had improved between 1870 and 1938 and that the TT of developing countries had deteriorated.

Prebisch's method was criticised for a number of reasons.

1. The inverse of the UK's TT could not be used to represent the TT 6f underdeveloped countries because the UK's NBTT did not represent industrial countries.

2. In addition, the UK bought primary commodities from developed nations, and prices for developed-country primary commodities may have decreased while prices for developing-country basic commodities may have soared.

3. Exports are valued at f.0.b., whereas imports are valued at c.i.f. Import prices in the UK may have fallen as a result of lower shipping costs, as import prices include freight expenses. However, a drop in import prices in the UK might occur without a drop in the prices of developing-country commodities. As a result, the UK's TT might improve without harming LDCs' terms of trade.

4. The traditional approach of calculating price indices ignores the introduction of new goods and differences in quality. Both are mostly applicable to manufacturers, skewing the results.

Spraos further claims that there is no reason to believe that core products will improve in quality. Consumers may, for example, switch from a cheaper brand of tea to a more expensive excellent brand. Such a movement exists. Commodities: Issues that would show up in the statistics as a bettering of trading terms. In addition, in subsequent years, emerging countries will process more raw products before exporting them. Such processing may not result in a change in the basic classification of commodities, but it would appear to improve the TT once again. In addition, for future years, pricing indices that attempt to account for quality variations have been constructed. There is no significant trend TT difference between the f indices that incorporate quality improvements and those that do not, according to the analysis of these indices.

Spraos made an attempt to improve on Prebisch's indexes. By combining multiple import and export indices and accounting for changes in transportation costs, he discovers that Prebisch's essential result - a fall in the TT of primary commodities - is maintained, though at a slower rate than Prebisch predicted.

The challenge in analysing TT changes after WWII is that the results are highly dependent on the time period chosen for analysis. The world economy grew swiftly in the decades following World War II until 1973, and demand for primary commodities was strong. Despite the fact that primary commodity prices fluctuated a lot, real commodity prices did not fall for a long time. Price fluctuations in primary commodities have also been a major source of concern for emerging countries. It was a prominent topic of discussion throughout the 1970s discussions for a new International Economic Order. The industrialised countries finally agreed to the poor countries' demand for a price-stabilization fund. However, the agreement was born despite the fact that the Fund's size was too modest to be effective, and it was never implemented. After the significant spike in oil prices in 1973-74, however, the scenario shifted dramatically. The global economy, with the exception of Asia's economies, has slowed significantly, wreaking havoc on primary prices. Grilli and Yang show that, from 1900 to 1986, the prices of non-oil primary commodities fell by around 0.6 percent per year relative to the prices of manufactured goods, continuing Prebisch's trend but at a slower pace.

SECTION B

3) Explain multilateral framework of international trade. Explain its main features.

Ans) Multilateral trade agreements or frameworks are made between three or more countries to strengthen the economy of member countries by exchanging of goods and services among them. It has an advantage over bilateral trade agreement because in a multilateral trade agreement tariffs are low and it makes it easier for businesses to import and export. Where as in a bilateral trade agreement, it is highly unlikely that a country will get a better trade deal. For e.g. often developed countries derive their benefits at the cost of the developing countries. Multilateral trade agreements are meant to provide an umbrella of collective security. However, they are very difficult to negotiate because there are too many parties involved and too many interests are at stake. It’s dispute settlement mechanism is much efficient and provides mutually acceptable solutions by protecting each members trading rights. In a multilateral framework, trade policies are constantly reviewed in order to improve transparency. This creates a greater understanding of the policies which the countries are adopting and it gives an opportunity to many countries to learn from it and also take it as a constructive feedback for reviewing their own policies. Multilateral trade agreement is beneficial to developing countries as it increases their trading opportunities and lets them expand their businesses and markets.

Towards the objective of ensuring free competition, there are two basic principles in the area of trade in goods in the WTO: (i) the Most Favoured Nation (MFN) Treatment principle and (ii) the National Treatment principle.

MFN treatment:

It prohibits discrimination between one country and another. A country that is a member of the WTO cannot provide an especially beneficial treatment to any country in the matter of export and import. In specific terms, this provision (Article I of the GATT 1994) says that when a country that is a member of the WTO (now on called simply "Member") gives any benefit in the matter of export and import to any country (whether Member or not), it must provide the same benefit to all other Members immediately and unconditionally. The title is derived from the fact that any concession given by a Member to the most favoured country has also to be extended to all Members.

National treatment:

It is the principle of non-discrimination as between an imported product and a like domestic product. A Member is prohibited from providing less favourable treatment to an imported product than provided to a like domestic product (Article I11 of GATT 1994).

4) What are the various forms of economic integration? How is trade diversion different from trade creation? Elucidate.

Ans) Economic integration is the unification of economic policies between different states, through the partial or full abolition of tariff and non-tariff restrictions on trade.

The trade-stimulation effects intended by means of economic integration are part of the contemporary economic Theory of the Second Best: where, in theory, the best option is free trade, with free competition and no trade barriers whatsoever. Free trade is treated as an idealistic option, and although realized within certain developed states, economic integration has been thought of as the "second best" option for global trade where barriers to full free trade exist.

Economics integration is meant in turn to lead to lower prices for distributors and consumers with the goal of increasing the level of welfare, while leading to an increase of economic productivity of the states.

The above Figure demonstrates as to how trade diversion could be welfare reducing to a country that enters an FTA. It shows the supply and demand curves for country A. PB and PC represent the free trade supply prices of the good from countries B and C respectively. We assume that A has a specific tariff tB = tC = t* set on imports from both countries B and C. The tariff raises the domestic supply prices to PTB and PTC, respectively. The size of the tariff is equal to PTB - PB = PTC - PC. It is quite clear that country A I will import the product from country C and will not trade initially with country B. Imports would be to the order of D1- S1.

After countries A and B form an FTA, A would impose zero tariff on imports from country B. Consequently, the domestic prices on goods from countries B and C would be PB and PTC, respectively. Since PB < PTC, country A would import only from country B after the FTA. At the lower domestic price, PB, imports would rise to D2 - S2. Since the initial price in country C is lesser than the price in country B, imports from B are considered as diverted from a more efficient supplier C to a less efficient supplier B.

Welfare Effects of RTA: Trade Diversion

It is evident from the Table above that the net national welfare effect can be either positive or negative. Usually, trade diversion is welfare reducing as highlighted earlier. However, in certain conditions the national welfare change could be positive under the trade diversion scenario as well. If the free trade supply price (PB) offered by country B is lower and closer to country C's free trade supply price PC, trade diversion still occurs after the FTA-formation. The welfare effects remain the same as far as the direction is concerned, however, they differ in magnitude. The consumer surplus gain is becoming larger due to the larger drop in the domestic price. Thus, in such cases, formation of an FTA that causes trade diversion could have a positive welfare effect. Thus, trade diversion need not necessarily be welfare reducing.

Trade Creation Trade creation under an FTA implies that imports are sourced from a more efficient producer within the region, at times involving a shift of imports away from- the rest of the world. Such a shift is welfare increasing in a member country of the FTA. In the above Figure 15.1 you should be able to see that if country A enters into a FTA with the more efficient supplier country C, there will be only trade creation and no diversion. Another example of trade creating effects, where country A forms an FTA with country B, is demonstrated in Figure above.

The supply and demand curves for country A are displayed in the figure. The supply prices of the good from countries B and C, respectively, are represented by PB and PC. As assumed earlier, A has a specific tariff tB = tC = t* set on imports from both countries B and C. The tariff raises the domestic supply prices to PTB and PTC respectively. The size of the tariff is denoted by t* = PTB - PB = PTC - PC. Including the tariffs, the pre-FTA price in country A (PA) is less than both PTB and PTC hence the product will not be imported. Instead, country A will meet its domestic demand with its own supply at S1 = Dl.

If countries A and B form an FTA and A fully eliminates the tariff on imports from country B, the tB, becomes zero but tC remains at t*. The domestic prices of goods from countries B and C become PB and PTc, respectively. Since PB < PA, country A would now import the product from country B after the FTA. At the lower domestic price PB, imports would rise to D2 - S2. It may be noted that trade now is generated in the post-FTA scenario from an efficient source within the region it is called trade creation. 

The net welfare effect for the country A can be assessed aggregating the gains and losses to consumers and producers. It has two positive dimensions: a) positive production efficiency gain (b) and a positive consumption efficiency gain (c). Thus, an FTA that leads to trade creation implies net welfare gains. I You should be able to show that the gain would be even larger if country A entered the FTA with the more efficient supplier country C.

The analysis of trade creation and trade diversion can also be extended to many markets and multiple countries of an FTA. Therefore, the aggregate effects of an FTA can be obtained by summing up the effects across markets and across countries. Finally, the net welfare effects are measured by taking both trade creation and trade diversion into account. If the positive effects from trade creation outweigh the negative effects from trade diversion, the FTA under consideration is said to be welfare improving.

It is for this reason both trade creation and trade diversion effects and to be c combined to assess the welfare-increasing effects of a customs union or RTA.

5) Describe the evolution of international monetary system. Examine the trends in the international monetary and financial systems.

Ans) The interdependence of the international monetary system is based on the idea that balances of payment are linked, according to economic theory. When one country's balance of payments is in surplus, the rest of the globe is in deficit, and vice versa. If one country has a positive trade balance, the rest of the globe has a negative trade balance. This has an impact on the currency exchange system. There are n-1 independent exchange rates in a world with n countries and n currencies. No country has the authority to set exchange rates. There would be an excessive number of preset exchange rates. There is just one degree of freedom, resulting in the redundancy problem, as theorists put it. The purpose of the extra degree of freedom was to keep prices steady, or in the case of the gold standard, to keep gold prices stable. With the fast increase of cross-border capital flows, the dilemma of the "impossible trinity" became more prominent. As you learned before, achieving the goals of a fixed exchange rate, an open capital account, and a monetary policy focused on domestic economic goals at the same time is unachievable.

The fixed exchange rate regime in numerous countries was dropped as a worthwhile goal at this point. Prior to 1971, the IMF could protect and maintain the anchored dollar system of fixed exchange rates under the fixed rates regime. Since 1971, and particularly after 1973, as the international monetary system moved toward flexible exchange rates, the IMF has lost its position as a defender of the international monetary system. The Fund's duty as the central bank of the international monetary system was subsequently moved to that of an ad hoc macroeconomic consultant and debt monitor. With the demise of the gold exchange standard, which operated as a price-stabilization mechanism due to the interdependence of the currency system, inflationary pressures were felt all over the world. As a result, in 1978, the IMF's Articles of Agreement were revised to include a focus on price stabilisation, as stated in the amended Article IV.

The elements that caused the 'Bretton Woods system to fail were covered in Unit 8.3. To recap, the United States opted to decouple the dollar from gold in 1971. In terms of the IMF's role, it is abundantly evident that the international monetary system was governed by industrialised countries, not the IMF, as originally intended. When the issue of monetary stabilisation in transition nations arose, the Fund had no clear solution to give. There is now no worldwide monetary system in the strict sense of the term. Each country has its own set of rules.

The IMF's position and functioning as a global agency with a developmental mandate has been heavily criticised. The IMF's credibility has been questioned over a number of problems, including whether IMF-backed programmes impose austerity on countries in financial distress. Alternatively, we should inquire as to whether IMF-backed policies will benefit bankers and elites. Similarly, one can wonder whether IMF-supported initiatives "impose" budget deficit constraints on priority areas like education and health. Is the IMF, on the other hand, unaccountable?

This has resulted in a number of distinct tendencies in the international monetary system. These developments are dispersed, and there is currently no one umbrella organisation that can be regarded to provide an international monetary and financial architecture. The following are some of the key trends:

1. domestic financial market deregulation and opening by countries since the early 1980s

   
   

2. internationalisation of domestic financial markets and institutions

   
   

3. companies and financial institutions approach international capital markets to raise needed funds

   
   

4. investors seeking investment opportunities abroad

   
   

5. countries allow foreign corporations and financial institutions to issue bonds and stocks denominated in different currencies (including their own) in      their domestic financial markets and allow foreign investors to buy their domestic securities

   
   

6. emergence of other international financial centres located in Europe and Asia along with the US bond and stock markets (the traditional international capital markets)

   
   

7. growth of offshore money and capital markets such as the markets for Eurobond etc.

   
   

8. integrated stock markets rapid globalisation of banking, insurance, and other intermediation businesses

   
   

9. large banks from the U.S, Europe, Japan etc. have global network of branches and subsidiaries

Thus, the international capital market is not a single market. Instead, it refers to a group of offshore and onshore capital markets that are closely interconnected to one another and in which domestic and foreign residents buy and sell many different types of financial instruments. It is true of banking, insurance, and other intermediation businesses as well.

6) Discuss the various instruments of trade protection. Differentiate between quotas and tariffs.

Ans)  We discuss each of these instruments of trade protection, in turn.

Tariffs

A tariff or import duty essentially alters the relative prices of traded goods vis a vis non-traded goods in the domestic market. Tariffs may be specific or ad valorem. Specific tariffs are levied as a fixed amount per unit of the good (e.g., Rs.400 per box of imported dates). While, ad valorem duties are levied as a fixed percentage of the total value of the goods (e.g., 30% duty on imported computer parts).

Using above Figure, we will cany out a simple cost-benefit analysis of the impact of a tariff on various economic agents like consumers, producers and the government in a partial equilibrium framework.

We assume that the country is a small open economy that cannot affect world market

prices. The implication of this assumption is that the tariff leaves world market

price of the good unaffected, while raising its prices in the domestic market.

In the Figure above we consider the domestic demand and supply curves of the imported good. The world market price of the good is Pw, and this is the price that would prevail in the domestic market under free trade. Thus, with free trade, domestic production of the good would-be QI, domestic demand Q2, and the difference Q1 Q2 would be imported.

A specific tariff rate oft per unit drives a wedge between the world price and domestic market price of the imported good. Post-tariff, price in the domestic market rises to (Pw + t). As a result, domestic production increases from Q1 to Q3, while consumption falls from Q2 to Q4.

Now let us consider the costs imposed by the tariff. Owing to the tariff, domestic consumers suffer a loss in consumer surplus equal to the area (a + b + c + d), compared to free trade. This loss arises because consumers must now pay a higher price (Pw + t) for the good and because they now consume Q4Q2 amount less of the good than with free trade.

However, domestic producers gain from the price rise, with the area a representing the increase in producer surplus. The government also gains from the tariff as it earns a revenue. The imports are now Q3Q4 units, each paying a tariff oft per unit, so the tariff revenue is given by the rectangle with area c. Clearly the loss to consumers exceeds the gain to producers and the government taken together, indicating that the tariff results in a net social loss to society equal to the sum of the areas b and d.

In the Figure above:

1. Area b measures the loss in social welfare from the production distortion due to the tariff. It represents the higher cost of producing Q1Q3 domestically rather than importing this amount.

   
   

2. Area d is the welfare loss due to the consumption distortion created by the tariff. It represents the cost of not consuming Q4Q2, an amount whose value to consumers exceeds the cost of importing it.

You should note that our partial equilibrium analysis of the impact of a tariff, focuses simply on the market for the imported good. Repercussions on several important issues like terms of trade, BOP, factor markets etc., are left out of this framework, as in case of our analysis of the benefits of free trade.

Our analysis does not attach any weight to employment in the sector being granted tariff protection. If the import-competing sector accounts for a significant share of total employment, the measures of welfare loss would be adjusted accordingly. Employment is often the most important reason underlying the imposition of protectionist trade policies.

Intuitively the following is clear:

1. under free trade, value added in domestic industry would be determined by world market prices of the final good and imported inputs.

2. with a tariff, domestic prices can exceed the world market prices. How this affects domestic value added would depend on the extent of price increase of the final good vis a vis that of intermediates and on the importance of the intermediates in the production process.

3. if production of the final good requires no intermediates, then the ERP equals the nominal rate of tariff on the final good.

4. if the tariff on final goods is higher than that on intermediates, then the ERP would be higher than the nominal rate of protection.

5. ERP could be negative, when tariffs on imports are too high compared to the tariff on the final good. Negative ERP indicates that trade protection could lower domestic value added as compared to free trade.

Quotas

Import quotas impose direct restrictions on the quantum of imports into a country. In practice quotas are administered through a system of import licenses. Only license holders are given permission to import specified quantities of the imported good into the domestic market. You will see that with a quota the domestic price of.an imported good will always be higher than its world market price. License holders buy the imported goods at world market prices and then sell at higher prices in the domestic market.

In  what follows we will examine the impact of an import quota under different market structures in the domestic economy. We first discuss the case of perfectly competitive markets and then that of monopoly.

The above Figure demonstrates the effect of an import quota when markets are perfectly competitive. D and S represent the demand and supply curves for the good before quota imposition. Under free trade, the world price Pw prevails and total domestic production is Q1 , demand is Q2, and Q1, Q2 amount is imported.

Now suppose an import quota is imposed, which restricts imports to Q1, Q3 (where, Q1 Q3 < Q1 42). Immediately with quota imposition, at the world price Pw, domestic demand falls short of total domestic production Policy plus imports. This excess domestic demand drives up prices in the domestic market, till the market clears.

The quota effectively shifts the domestic supply curve to S', by the amount of the quota. The economy moves to the new equilibrium E', where price has risen from Pw to P', domestic production has increased from Q1, to Q4, while domestic demand has fallen from Q2 to Q5. At E', imports, restricted by the quota, are equal to the amount Q4 Q5 (note that Q3QI = Q5Q4 = import quota).

A tariff rate equal to P'- Pw, is the tariff equivalent of the quota. It would have restricted imports to the same level as the quota and had the same effect on domestic prices. However, it may not always be feasible to implement the tariff equivalent of a quota, as the rate may be too high to be acceptable.

You should see that as in case of a tariff, a quota involves a loss in consumer surplus equal to the area (a + b + c + d). This is offset by a rise in producer surplus equal to the area a. But an important difference between tariffs and quotas arises from the fact that with a quota the government does not earn revenues as in case of a tariff. The area c therefore does not accrue to the government, rather it represents the quota rent, which may be captured by the import-license holders, who buy at the world price Pw and sell at a higher price P', making a profit of (P' - Pw) per unit of imports. If c accrues to the license holders and is counted as part of social gain, then the social loss from the quota is equal to the area (b+ d), same as in case of a tariff.

Often foreign exporters have the right to sell directly in the domestic market. In that case the quota rent c would accrue to foreigners and it would be a social loss from the domestic country's point of view.

Another disturbing possibility, and one that is often observed in practice, is that the quota rent may not accrue to license holders. Rather it may be dissipated in rent-seeking activities, like paying bribes to acquire import licenses and so on. In that case, the area c would be a social loss and the total cost imposed by the quota would equal the area (b+c+d), which is more than in case of an equivalent tariff. In fact, quota rents have been estimated to be as high as 24% of GNP in developing countries like Kenya.

Governments in developing countries have the option to auction import licenses. A competitive bidding process would drive the price of licenses up to (P' - Pw) per unit of imports and the government would earn revenue equal to the area c. If this process worked smoothly, the effects of a tariff and quota would be equivalent. However, developing country experiences demonstrate that the auction process may also run into difficulties. The auctions may not be competitive and collusion among bidders might subvert the entire process.

7) Critically examine the relative merits and demerits of the fixed and flexible exchange rates.

Ans) Merits and Demerits of Fixed Exchange Rate System

1. There are various types of exchange rates that are prevalent in the market, but the most commonly used exchange rate systems are fixed exchange rate and flexible exchange rate systems.

2. Fixed exchange rate system is referred to as the exchange system where the exchange rate is fixed by the government or any monetary authority. It is not determined by the market forces.

3. Flexible exchange rate system is the exchange system where the exchange rate is dependent upon the supply and demand of money in the market.

4. In a flexible exchange rate system, the value of the currency is allowed to fluctuate freely as per the changes in the demand and supply of the foreign exchange.

5. The main aspect of a fixed exchange rate system is that there must be a reliability that the government will be able to perpetuate and maintain the exchange rate at the mentioned degree of level. Often, if there is a deficit in the balance of payment in a fixed exchange rate system, governments must take care of the gap using their official reserves.

6. If people are aware that the number of reserves is insufficient, then they begin to be sceptical about the capability of the government to maintain the fixed rates.

7. This may increase the hypothesis of devaluation. When this reliance translates into aggressive purchasing of one currency, thereby forcing the government to devalue, it is known to compose a notional attack on the currency.

8. Fixed exchange rates are liable to such types of attacks as observed in the time period before the subside of the Bretton Woods system.

9. A flexible exchange rate system provides the government with more flexibility, and it does not need to perpetuate large stocks of foreign exchange reserves. The vital merit of flexible exchange rates is that movements in the exchange rate instinctively takes care of the deficits and surpluses in the balance of payment.

10. Also, nations gain independence in regulating their monetary policies, since they do not have to interfere with maintaining the exchange rate, which is instinctively taken care of by the market.