Assignment Code: MEC-007/AST/2022-23

Course Code: MEC-007

Assignment Name: International Trade and Finance

Year: 2022-2023

Verification Status: Verified by Professor

Answer all the questions.

SECTION A

Answer the following questions in about 700 words each. 20x2

Q1) Critically discuss the Ricardian theory of Comparative Advantage. How is it different from Adam Smith’s theory of Absolute Advantage?

Ans) The comparative cost theory is based on the variations in manufacturing costs of comparable goods between nations. Due to the geographical division of labour and industry specialisation, production costs vary throughout nations. Each nation specialises in producing the good or service with the lowest comparative cost of production. Therefore, when a country engages in trade with another country, it will export goods for which its comparative production costs are lower and import those for which they are higher. According to Ricardo, this forms the foundation of global trade.

Assumptions of the Theory

The following presumptions form the foundation of the Ricardian doctrine of comparative advantage:

1. There are just two, let's call them A and B.

2. They both produce X and Y, the same two commodities.

3. Both nations share similar tastes.

4. The sole factor of production is labour.

5. The cost of labour, or the number of labour units required to manufacture each good, determines the prices of the two goods.

6. Under the law of constant costs or returns, commodities are created.

7. The barter system is the foundation for trade between the two nations.

8. There are no trade barriers or limitations on the transfer of commodities between the two nations, ensuring unrestricted trade.

9. Transport expenses are not incurred when goods are transported between the two nations.

10. The global market is ideal in that it maintains a constant exchange rate between the two goods.

Cost Differences

Three categories of cost differences absolute, equal, and comparative are used to describe the notion of comparative costs.

1.  Absolute Differences in Costs: When one nation produces a good at an absolute lower cost of production than the other, there may be absolute variances in costs.

2. Equal Differences in Costs: When two items are produced in both nations at the same cost difference, there are equal cost discrepancies. No country benefits from trade when cost disparities are equal. As a result, global trade is impossible.

3. Comparative Differences in Costs: When one country has an absolute advantage in producing both goods, but a comparative advantage in producing one good over the other, there are comparative variances in cost.

Absolute vs. Comparative Advantage

Two key ideas in economics and global trade are absolute advantage and comparative advantage. They have a significant impact on how and why countries and companies allocate resources to the creation of specific commodities and services. Absolute advantage refers to a situation in which one party can produce a good more quickly and profitably than another nation or rival company.

Absolute Advantage

The idea of absolute advantage is based on the distinction between the various capacities of businesses and nations to create commodities efficiently. As a result, absolute advantage considers how well a particular product is produced. Additionally, it considers how to manufacture goods and services for less money than the competitors by using fewer inputs during the production process. This study aids nations in preventing the production of goods and services that would generate little to no demand and ultimately result in losses. The kinds of goods a nation choose to manufacture can be significantly influenced by its absolute advantage in a given industry.

A few of the elements that can give an organisation an unbeatable advantage include:

1. Lower labour costs

2. Access to an abundant supply of (natural) resources

3. A larger pool of available capital

Comparative Advantage

Comparative advantage looks at production as a whole. In this instance, the perspective comes from the fact that a nation or company has the capacity to manufacture a range of goods and services as opposed to concentrating on a single one. The lost gains that could have been attained by selecting an alternative that was also an option are equal to the opportunity cost of the supplied option. In general, analysts would compute the opportunity cost of selecting one alternative over the other when the profit from two items is recognised.

Q2) Explain the various concepts of terms of trade. Critically examine the behaviour of terms of trade as explained by Prebisch.

Ans) The ratio of the export price index to the import price index is known as the terms of trade. A country has favourable terms of trade if export prices rise faster than import prices because it can buy more imports for the same quantity of exports. The proportion of a nation's export prices to its import prices is known as the terms of trade. The value of a country's total exports minus its total imports is what makes up TOT indices. By dividing the price of exports by the price of imports and multiplying the result by 100, the ratio is calculated.

A rise or improvement in a nation's TOT often denotes that export prices have increased while import prices have either held steady or decreased. In contrast, export prices may have decreased, but not by as much as import prices. Export prices can have climbed more quickly than import prices, or they might have declined while import prices have remained stable. An improved TOT could come about in any of these conditions.

A TOT is somewhat reliant on pricing, exchange rates, and inflation. The TOT is influenced by a wide range of additional elements, some of which are unique to certain businesses and sectors. One such element is scarcity, or the limited supply of items accessible for trade. The more products a vendor has on hand, the more products it will probably sell, and the more products the seller can purchase using money made from sales.

By dividing an export price index by an import price index, one may determine a country's terms of trade. Then, multiply this ratio by 100: TOT=Pexports/Pimportsx100

A rising TOT ratio shows that a nation is relatively exporting more items than it is importing. This may eventually result in a trade surplus. The inverse would be accurate if TOT was falling.

The Behaviour of the TT

According to Prebisch, developing nations could not implement a development strategy focused on expanding the agriculture sector and exporting the increased output. Since developing nations lack a significant local ability to create capital goods, any attempt to increase the growth rate of an economy would necessitate a higher investment ratio and larger imports of capital goods. However, as more agricultural products were exported, the terms of trade would weaken, resulting in a steady increase in export revenues. As a result, attempts to increase the growth rate would be ineffective because export profits wouldn't be sufficient to pay for the imports of capital goods, which would result in BOP issues.

Prebisch supported his claim that the terms of trade of developing countries were declining with a thorough statistical research. He calculated the UK's TT since he was unable to acquire information regarding the terms of trade of underdeveloped nations. Prebisch discovered that between 1870 and 1938, the TT of the UK had improved, leading him to draw the conclusion that the TT of developing nations had declined. Prebisch's method was criticised for a number of reasons.

1. Because the UK's NBTT was not indicative of industrial countries as a whole, it was invalid to use the inverse of the UK's TT to represent the TT of developing nations.

2. Additionally, because the UK bought main goods from wealthy nations, the cost of these goods may have grown while it may have decreased for those from developing nations.

3. Imports are valued on a c.i.f. basis whereas exports are valued f.o.b. Since import prices also include freight charges, it is possible that prices of imports into the UK have decreased as a result of a decrease in transportation expenses. However, the decline in import costs in the UK might take place without a decline in the costs of exporting goods from underdeveloped nations. Therefore, the UK's TT might be improved without harming LDCs' terms of trade.

4. The standard approach of calculating price indices ignores the introduction of new goods and differences in quality. Both primarily apply to manufacturers, which skews the findings.

5. Aside from these objections of Prebisch's historical study, economists could find no proof to back up the claim that the TT declined in the decades immediately following World War II.

SECTION B

Answer the following questions in about 400 words each. 12x5

Q1) Explain multilateral framework of international trade. Explain its main features.

Ans) A multilateral agreement is a trade pact made up of three or more nations that aims to lower trade restrictions like tariffs, subsidies, and embargoes that restrict a country's capacity to import or export commodities. They are regarded as the most effective means of promoting a truly global economy that equally opens markets to both small and large countries.

Trade pacts are often either bilateral, comprising just two countries, or multinational. Multilateral agreements are far more difficult to negotiate than bilateral agreements due to their very structure, which calls for concessions from multiple countries that have historically employed trade barriers to defend specific industries or domestic commodities.

By trading commodities and services, multilateral trade frameworks or agreements are created between three or more nations in order to boost the economies of its respective members. A country is extremely unlikely to obtain a better trade deal under a bilateral trade agreement. For instance, affluent countries frequently profit at the expense of underdeveloped nations. The purpose of multilateral trade agreements is to offer a blanket of shared security.

Main Features of International Trade

1. All parties to multilateral agreements must treat one another equally. No country can offer one country a better trade deal than it offers another. The playing field is thus levelled. Particularly important are rising market nations. Because many of them are smaller, they are less competitive. The Most Favoured Nation Status grants a nation the greatest possible trading conditions from a trading partner. The majority of the benefits of this trading status go to developing nations.

2. The second advantage is that it boosts trade for all parties involved. Their businesses benefit from cheap tariffs. This lowers the price of their exports.

3. The third advantage is that it harmonises trade laws for all trading partners. Because they adhere to the same laws in every nation, businesses save money on legal fees.

4. The ability for nations to simultaneously negotiate trade agreements with multiple nations is the fourth advantage. Trade agreements must pass a thorough review process.

5. The fifth advantage is relevant to developing markets. In general, bilateral trade agreements favour the nation with the strongest economy. This disadvantages the weaker country, but over term, strengthening emerging markets benefits the established economy.

Q2) What are the various forms of economic integration? How is trade diversion different from trade creation? Elucidate.

Ans) Economic integration is the process through which two or more states in a large geographic area remove various trade obstacles in order to promote or defend a number of economic objectives. Even though there are numerous different types of economic integration, it may be easiest to think of the term as a continuum that runs from loose affiliation at one end to a nearly total fusion of national economies at the other. The various forms of economic integration are:

1. The economic integration of several countries or states may take a variety of forms. The term covers preferential tariffs, free-trade associations, customs unions, common markets, economic unions, and full economic integration.

2. The parties to a system of preferential tariffs levy lower rates of duty on imports from one another than they do on imports from third countries.

3. In free-trade associations no duty is levied on imports from other member states, but different rates of duty may be charged by each member on its imports from the rest of the world.

4. A further stage is the customs union, in which free trade among the members is sheltered behind a unified schedule of customs duties charged on imports from the rest of the world.

5. A common market is an extension of the customs union concept, the additional feature being that it provides for the free movement of labour and capital among the members.

6. The term economic union denotes a common market in which the members agree to harmonize their economic policies generally.

7. Finally, total economic integration implies the pursuit of a common economic policy by the political units involved.

Trade Creation and Trade Diversion

Trade creation is the amplified trade that occurs between member countries of trading blocs following the arrangement or development of the trading block. It is an economic term associated with international economics in which trade is created by the arrangement of a social union. This comes about as the exclusion of trade barriers allows greater specialization according to proportional advantage. This means that prices can drop and trade can thus enlarge. Trade creation is when the trade is formed by financial amalgamation e.g., now the UK buys meat from inside the EU.

Trade diversion is the decrease in trade following the structure of a trading community as trade with low-cost non-trading block members is replaced by trade with comparatively high-cost trading union members. It is a financial term associated with international economics in which trade is abstracted from a more proficient exporter towards a less efficient one by the formation of a free trade agreement.

Q3) Describe the evolution of international monetary system. Examine the trends in the international monetary and financial systems.

Ans) The operational system of the financial environment, which comprises of financial institutions, multinational enterprises, and investors, is referred to as the international monetary system. The international monetary system offers the institutional framework for setting the guidelines and practises for international payments, setting exchange rates, and facilitating capital mobility.

Different nations' fixed exchange rate systems were given up as a worthwhile objective. Prior to 1971, the IMF was able to protect and oversee the anchored dollar system of fixed exchange rates. Since 1971, and particularly after 1973, when the international monetary system began to move toward flexible exchange rates, the IMF has lost its function as the system's protector. The Fund's position as the hub of the global monetary system was then changed to one of ad hoc macroeconomic consultant and debt monitor.

The US government made the decision to separate the dollar from gold in 1971. Regarding the role of the Fund, it is abundantly evident that industrialised nations, not the IMF, as intended, were in charge of the global monetary system. The Fund had no comprehensive strategy for monetary stabilisation to offer when the challenge of the transition countries arose. There isn't now a global monetary system in the strict sense of the word. Every nation has its own unique system.

These have led to a number of distinct tendencies in the global monetary system. There is now no single organisation that can be said to be creating an international monetary and financial architecture because these tendencies are scattered. Below is a summary of these trends:

Since the early 1980s, governments have been deregulating and expanding their domestic financial markets.

1. Local financial institutions and markets are becoming more global.

2. To raise the necessary funds, businesses and financial institutions turn to global capital markets.

3. Investors looking for international investment options.

4. In their domestic financial markets, nations let foreign firms and financial institutions to issue bonds and stocks denominated in a variety of different currencies. They also permit foreign investors to purchase domestic assets.

5. Other global financial hubs, including those in Europe and Asia, have begun to emerge alongside the US bond and stock markets.

6. Expansion of international financial and stock markets, including those for Eurobonds, etc.

7. Market integration for stocks.

8. Banking, insurance, and other firms that serve as intermediaries are rapidly becoming worldwide.

9. American, European, Japanese, and other large banks network of branches and subsidiaries around the world.

As a result, the global capital market is not one market. Instead, it refers to a collection of interconnected offshore and onshore capital markets where local and foreign individuals can purchase and sell a wide range of financial assets. The same is true for the banking, insurance, and other intermediary industries.

Q4) Discuss the various instruments of trade protection. Differentiate between quotas and tariffs.

Ans) Protecting native industry from unfair foreign competition is the goal of trade protectionism. Tariffs, subsidies, quotas, and currency manipulation are the four main instruments of trade protectionism. Trade protectionism is a deliberate and measured policy used by a country to limit imports while fostering exports. It is carried out in an endeavour to advance the nation's economy above all other economies.

Tariffs: Tariffs are tariffs on imports. Tariffs used to be the most popular trade protection since they generate government revenue. Specific and ad valorem tariffs exist. A particular tariff is a fixed levy on each imported commodity. When importing, a predetermined proportion of the product's worth must be paid ad valorem. GATT and WTO discussions have made tariffs less widespread.

Quotas: Quotas are similar to tariffs in that they limit imports; only a certain number of commodities can be imported within a given time. Like tariffs, quotas attempt to raise domestic pricing and assist local manufacturers. Quotas don't create government revenue, unlike tariffs. Tariffs help foreign producers with import licences.

Subsidies: Subsidies help domestic producers compete with foreigners. EU subsidies encourage home farmers to produce and help them compete against cheaper international agricultural products. Subsidies cost the government money, whereas tariffs produce revenue.

Nontariff Barriers: Nontariff barriers include health and safety, anti-dumping, administrative, and custom entry restrictions. They restrict a country's importation of foreign goods but are harder to measure and negotiate in the WTO.

The Difference between Quotas and Tariffs

Quotas and tariffs raise domestic pricing to safeguard domestic industry. Administration and effects vary. Quotas limit imports of foreign goods. Imported items are subject to tariffs. Tariffs provide income for the importing country's treasury, whereas quotas, also dubbed "quota rents," benefit foreign exporters who can sell commodities subject to the quota at higher rates and earn more per unit. Both taxes and quota rents are paid by importers. Quotas deny the importing country's government revenue.

Administrating quotas is more difficult than tariffs. Customs collects tariffs on incoming goods. Customs authorities must monitor imports to guarantee no products exceeding the quota amount are imported, or they can grant licences to specific corporations to import the quota amount. The exporting country can also impose a voluntary export restraint.

Q5) Critically examine the relative merits and demerits of the fixed and flexible exchange rates.

Ans) The relative benefits and drawbacks of fixed and floating exchange rate regimes in light of the Bretton Woods regime's experiences and the controlled or filthy floating regime's results after 1973.

1. Monetary Policy Autonomy: In order to maintain a stable exchange rate, central banks are required to intervene on the foreign currency market. However, there is no such responsibility under a floating rate system.

2. Symmetry: The Bretton Woods arrangement allowed the United States to independently control global monetary circumstances. Under a floating rate system, this is not the case. Therefore, in a floating rate regime, the inherent imbalances would disappear. The opportunity for the United States to affect its exchange rate versus other currencies is the same as for all other nations.

3. Exchange Rates as Automatic Stabilisers: Prior to exchange rate realignments, there used to be protracted periods of speculation under the Bretton Woods system. To stabilise the economies, policy-driven changes in exchange rates were sought after.

4. Discipline: Under a floating rate environment, where central banks are not required to set their exchange rates, they may adopt inflationary policies; under a fixed exchange rate regime, the likelihood of this happening is much lower. Thus, the autonomy of monetary policy comes at a cost.

5. Speculation: Under a regime with floating exchange rates, speculating on exchange rate movements may result in a significant decrease in market stability, adversely affecting the internal and external balance of a nation.

6. International Trade and Investment: Flexible exchange rates increase the irrationality of global prices, harming both global investment and trade.

7. Uncoordinated Economic Policies: Competitive currency practises under a floating exchange rate regime could be detrimental to the global economy. Countries may undertake policies without taking beggar-thy-neighbour considerations into account.

8. Uncertainty: The volatility of the exchange rate rises when the exchange rate is floating. More frequently than under a fixed rate system, central banks must intervene to control wild variations in exchange rates. Due to the volatility nature of exchange rate changes, a floating exchange rate regime fosters more economic uncertainty than a fixed exchange rate regime.