Economics Assignment

Mohib M Qureshi
T.Y.B.Com Div:B Roll No:274

Q.1. Discuss the changing trends in tax and non tax revenue in India? Ans: The Government raises finance for its expenditures from both tax and non tax revenue sources (A) TAX REVENUE India has a well-developed tax structure. The power to levy taxes and duties is distributed between the Central and the State governments and local bodies. T he central government levies taxes on income (except tax on agricultural income, which the state government can levy) ,customs duties ,central excise & service tax. Value Added Tax (VAT), stamp duty ,state excise ,land revenue & tax on professions are levied by the state governments. Local bodies levy tax on properties , octroi and for utilities like water supply , sanitation etc. 1.Trends in Gross Tax Revenue & Tax-GDP Ratio : Collection of direct and indirect taxes has increased many times since 1990-91 because of reduction in tax rates simplification of tax procedures and high rate of GDP. Low to negligible tax contributions from the agricultural sector, along with numerous exemptions are partly responsible for the relatively low tax revenueGPD ratio in India. Trends in Gross Tax Revenue (Rs Crore) Year Tax Revenue % of GDP 57,576 10.1 1990-91 2002-03 2009-10 2,16,266 4,59,444 8.8 7.0

1. Relative Share of Direct & Indirect Taxes: In 1960s, indirect used to contribute about 71 percent to the total tax revenue. The relative contribution of indirect taxes rose to about 83 per cent in1990-91.Since 1990-91 , this trend has reversed and there has been a progressive decline in the percentage contribution of indirect taxes.The growing contribution of direct tax is largely due to the increase in corporate income tax Changing Share of Direct and Indirect Taxes Direct Taxes Indirect Taxes Year 1990-91 2004-05 2009-10 19.1 43.3 58.6 80.9 56.1 39.5

a) Corporate Income Tax : Refers to a tax levied on the profits made by companies or associations. If the company is domiciled in India the tax rate is a flat 30% .But for a foreign company, the tax rate depends on a number of factors and considerations. Corporate income tax is the most important direct tax in terms of revenue collection & contribution to total tax revenue. This is because of growing corporate profits after introduction of reforms.

Year 1990-91 2004-05 2009-10

Trends in Corporate Income Tax Rs Crore 5,335 82,680 2,44,630

%of Total Tax Revenue 9.3 27.1 39.0

b) Personal Income Tax : Personal income tax is levied on the total income of the individual after some permissible deductions. It is a progressive tax i.e. the tax rates rise with increase in income. At present the personal income tax rates are as follows: Slabs (Rs) 0-160000 160001-500000 500001-800000 800001 & above Trends in Personal Income Tax Year 1990-91 2004-05 2009-10 Rs Crore 5,371 49,268 1,22,280 % of Total tax revenue 9.3 16.2 19.5 Rate 0 10 20 30

4.Trends in Indirect Taxes: The burden of these taxes may be shifted by the manufacturer, either wholly or partially, to the consumer in the form of higher prices. These taxes have been used by the govern to raise revenue but also to achieve different socio-economic objectives like control of prices , maintaining sufficient supply of essential commodities and promote growth. Major Indirect Taxes: (a) Excise Duty : Central Excise Duty is levied on those goods which are manufactured in India & are meant for home consumption. There has been a declining trend in the rate of excise duty since 1990-91. The peak excise duty rate is 10% at present. Trends in Excise Duty Year 1990-91 2004-05 Rs Crore 24,514 99,125 %of Total Tax Revenue 42.6 32.5

2009-10

1,04,659

16.7

(b) Customs Duty: Customs Duty is a type of indirect tax levied on goods imported into India as well as goods exported from. Import duties in India are generally levied on ad valorem basis , that is , as a percentage of the price of the commodity. The peak rate of customs duty at present is 10%. Trends in Customs Duty Year 1990-91 2004-05 2009-10 Rs Crore 20,644 57,611 84,244 % of Total Tax Revenue 35.9 18.9 13.4

(c) Service Tax : Service Tax is an indirect tax levied on certain services provided by certain categories of persons/firms/agencies. service tax collections have shown a steady rise since its inception in 1994 . Trends in Service Tax Year 1995-96 2004-05 2009-10 Rs Crore 862 14,200 58,454 % of Total Tax Revenue 0.8 4.7 9.3

(d) Goods and Services Tax : The Government of India has decided to merge all taxes like service tax, excise and VAT into a common Goods and Service Tax by the year 2011. (B) Non-TAX REVENUES Non Tax Revenue(NTR) is defined as all revenues , other than taxes, accruing to the Government through its Ministries, Departments & Agencies (MDAs)from their operations, either through the use of Government assets or facilities to provide services or through the enforcement of regulations that require stipulated payments to be made to Government through its MDAs. Non Tax Revenue in India is composed of the following revenue items: (a) Fines , penalties & forfeitures; (b) Sale of goods & services , including all goods & services provided by MDAs using Government assets&/or facilities. (c) Rent of government lands , buildings & houses. (d) Fees & charges (e) Licenses

(f) Income on Investments Interest on Loans Dividends (g) Donations & contributions Non-tax revenue has increased many times since 1990-91 as the government is trying to increase the efficiency of the use of its assets & to generate greater revenue internally from its operations. Incomes from interest, dividends & fees & charges have increased significantly since 1990-91. Trends in Non Tax Revenue (Rs Crore) Year 1990-91 2002-03 2009-10 Non-Tax Revenue 11,976 72,290 1,16,014 Percentage of GDP 2.1 3.0 1.8

Q.2a. Explain the classification of public expenditure in India? Ans: The term public expenditure refers to the expenses of public authorities like the Central, state& local governments. Public expenditure occupies a very important place in the study of public finance. Public expenditure is incurred basically to maximize social welfare. Classification of public expenditure refers to the systematic arrangement of different items on which the government incurs expenditure 1. Revenue & Capital Expenditure (a) Revenue Expenditures are current or consumption expenditures incurred on public administration, defence force, public health & education , maintenance of government machinery , subsides & interest payments. Revenue expenditure of the central government in 2009-10 was Rs 9,08,011 crore which was 13.9 %of the GDP. Revenue expenditure is classified into development & non development expenditure. (i) Development Expenditure : The part of revenue expenditure that directly or indirectly contributes to the development of the country is known as development revenue expenditure (ii) Non development Expenditure :The part of revenue expenditure that may not directly contribute to economic development is known as non-development revenue expenditure. (b) Capital Expenditure is incurred on building durable assets , like highways, multipurpose dams, irrigation projects, buying machinery & equipment. They are a non recurring type of expenditure in the form of capital investments. Capital expenditure of the Central Government in 2009-10 was Rs 1,10,515 crore, which was 1.7 % of the GDP. It is essential for the government to invent in infrastructure facilities as the private sector will not be interested in making such investments.

In mixed economics like India , the government also incurs capital for setting up public sector enterprises. Not all capital expenditures are productive. Most capital expenditures are made throw borrowings. 2. Productive & Unproductive Expenditures This classification was made by Classical economists on the basis o creation of productive capacity.

(a) Productive Expenditure : Expenditure on infrastructure development, public enterprises or development of agriculture increase productive capacity in the economy %& bring income to the government through tax & non-tax revenues. Thus they are classified as productive expenditure. (b) Unproductive Expenditure : Expenditures in the nature of consumption , such as, defence , interest payments , expenditure on law & order , public administration do not create any productive asset which can bring income & returns to the government. Such expenses are classified as unproductive expenditures.

3. Non-Transfer & Transfer Expenditure (a) Non- transfer Expenditures are incurred for buying or using goods & services. These include expenditure on defence , education, public health etc. In return for such expenditures, the government gets goods & services. Investment expenditures on capital assets also non-transfer expenditures (b) Transfer Expenditures refer to those expenditures against which there is no corresponding transfer of real resources i.e. , goods or services. These include expenditures incurred in old age pension, unemployment allowance, sickness benefits, welfare benefits , interest payments on public debt & subsides. 4. Plan & Non-Plan Expenditure In India , government expenditure is divided into plan and non plan Expenditure. Some economists & policy makers believe that such a distinction does not serve any purpose & should be discarded , but the government continues to use this classification in the budget. (a) Pan Expenditure: Refer to the spending of the annual funds allocated by the Central government for development schemes outlined in the ongoing Five-Year Plan. The plan expenditure of the Central Government in 2009-10 was Rs 3,02,199 crore. (b) Non-Plan Expenditure : Include all those expenditures of the government that are not included in the ongoing Five-Year Plan. They include both development & non-development expenditure. They also include expenditure on maintaining the assets created in previous plans. The non-plan expenditure of the Central Government in 2009-10 was Rs 7,16,327 crore. Both plan & non- plan expenditures can be divided into revenue & capital expenditure.

5. Daltons Classification Economist Huge Dalton has provided the following comprehensive classification of public expenditure. (i) Expenditures on political executives i.e., maintenance of ceremonial heads of state, like the President. (ii) Administrative expenditure to maintain the general administration of the country like government departments & offices. (iii) Security expenditures to maintain the armed forces & the police force. (iv) Expenditures on administration of justice include maintenance of courts judges, public prosecutors. (v) Developmental expenditures to promote growth & development of the economy , like expenditure on infrastructure , irrigation etc (vi) Social expenditures on public health , community welfare , social security etc (vii) Public debt charges include payment of interest & repayment of principal amount. Q.2b. Discuss the causes for increase in public expenditure in India? Ans: The size of public expenditure has been rising in developed countries since early twentieth century & in developing countries since the middle of twentieth century. Increase in public expenditure has been explained by Wagners Law & Wiseman-Peacock Hypothesis. In early twentieth century , German economist Adolf Wagner observed that there are tendencies for activities of the government to increase both extensively & intensively. Wiseman-Peacock hypothesis was put forward by British economists Wiseman & Peacock based on their study of public expenditure in the U.K. for the period 1891-1955 Total Public Expenditure (Revenue & Capital) of the Central Government Year 1990-91 2007-08 2009-10 Rs Crore 1,05,298 7,12,671 10,18,526 % of GDP 19.7 14.4 15.3

1. Defence : One of the major contributors to rising public expenditure in India is the growing defence expenditure. Defence expenditure has increased from Rs 3,600 crore in 1980-81 to Rs 86,879 crore in 2009-10. 2. Population : In 1951, Indias population was 36 crore. It rose to 102.9 crore in 2001. This massive growth in population has made it necessary for the government to spend ever increasing amounts on education , health, infrastructure, subsidies & development programmes.

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Rise in National Income : Rise in public expenditure is directly related to rise in national income & per capita income. This is because , as income rises beyond subsidence level, & the basic necessities of people are satisfied, demand for public goods like education, communication, transportation, health care etc. in India from 1980-81 to 2007-08, the national income has increased at the rate of 5.7 per cent per annum. Over the period, per capita income also rose at the rate of3.6 per cent per annum. Urbanization : With economic development & industrialization , urbanization has taken place. In 1951 , the percentage of urban population was 17 per cent , whereas in 2001 it was around 28 per cent. With urbanization , public expenditure on urban infrastructure has increased. Subsidies : The government gives subsidies to different sectors in order to make essential goods & services affordable to the poor. They are also given to promote a particular sector that is considered important for the growth of the country, like the export sector, small scale sector. In India Central Government subsidies hav increased from Rs 9,581 crore in 1990-91 to Rs 1,06,004 crore in 2009-10. Development Programmes :The government of India has always been committed to planned development. This requires heavy investments in various physical & social infrastructure projects. Current ongoing projects like Bharat Nirman, Golden Quadrilateral & Sarva Shiksha Abhiyan are ambitious projects requiring huge expenditure. The Government, plan expenditure was Rs 3,02,199 crore in 2009-10. Poverty Alleviation & Employment Generation: As part of the planned programme, the government has launched several programmes to directly attack the problems of poverty for their implementation. Servicing of Public Debt : Most plan capital expenditures in India have been financed through public debt from various sources. There has been a continuous growth in the total outstanding debt of the government. The public debt of the Central government rose sharply from 41.6 % of GDP in 1980-81 to 56.7 % in 2009-10. It has increased from Rs 2604 crore in 1980-81 to Rs 211643 crore in 2009-10. Administrative Machinery: Indian governments administrative machineries vast & has expanded many times over the years. Maintenance of various ministries, departments & offices, payments of salaries to a large staff has increased administrative expenditures over the years.

10. Judiciary & Internal Security : India has a strong & extensive judicial system that is designed to protect the rights of citizens with increase in population, this system has grown many times. At present the expenditure on judiciary & internal security is not adequate and is not being properly. 11. Democracy : India is the worlds largest democracy,. Periodic elections & maintenance of the political representatives have increased public expenditure to a great extent over the years. Like India , such as , payment of subsidies & interest, poverty alleviation & planning.

a) b) c) d)

e) a) b) c) d) e)

Q.3a) What is public Debt? Explain the types of public Debt Ans) Public Debt is defined as financial obligations accepted by the governmentby way of raising loan or funds, whether within or outside the country for financing public activities and which are redeemable with in a specific period of time. It is clear from above definition that the public debt implies following things: 1) Public debt is a financial obligations acceptable by the government. 2) Public debt is done by the way of raising loans inside or outside the country. 3) Public debt is done to finance the public activities. 4)Public debt is redeemable with specific period of time. Types of Public Debt or classification of public Debt 1) Internal and External Public Debt: The public debt on the basis of regions from which the borrowing is done is classified into two categories. A. Internal Public Debt. B. External Public Debt. A. Internal Public Debt: Internal Public Debt a debt which is done by the government inside the country. Internal Public Debt is done by the government by issue of bonds, and sale of treasury bills to general public and financial institutions. Internal Public Debt is less burdensome on nation as it has to be repaid in domestic currency. Internal Public Debt does not create any pressure on the government regarding the utilization of loan. The government is free to utilize the borrowed amount according to the requirements of the nation. Internal Public Debt maybe voluntary or compulsory. B. External Public Debt: External Public Debt is a debt which is done outside the country. External Public Debt is done from foreign government, world financial institutions like World Bank, Asian Development Bank, International Monetary Fund etc. External Public Debt is more burdensome as it has to be repaid in foreign currency. External Public Debt is generally tied loans. It creates pressure on the borrowing country to utilize the loan for the specific projects for which it is sanctioned. External Public Debt can be only voluntary. 2) Productive and Unproductive Public Debt: The public debt on the basis of creation of productive asset is classified into two categories. They are as follows: A. Productive Public Debt. B. Unproductive Public Debt. A. Productive Public Debt:

a) Productive Public Debt is a debt which is done by the government for investment in economic and social infrastructure like development of roads, railways, telecommunication, power, schools, hospital etc. b) Productive Public Debt helps to increase the productive capacity of a nation. c) Productive Public Debt helps to generate income which further builds up the repayment capacity for the nation. d) Productive Public Debt is less burdensome on as it generates repayment capacity for the nation. B. Unproductive Public Debt: a) Unproductive Public Debt is a debt which is done by the government for the purpose of defence, maintenance of law and order, public administrations etc. b) Unproductive Public Debt does not help to increase the productive capacity of a nation. c) Unproductive Public Debt does not help to generate repayment capacity for the nation. Hence it is also referred to as Dead weight Public Debts. d) Unproductive Public Debt is more burdensome on nation as it does not generate repayment capacity for the nation. 3) Funded and Unfunded Public Debt: The Public Debt on the basis of duration of loan is classified into two categories. They are as follows: A. Funded Public Debt. B. Unfunded Public Debt. A. Funded Public Debt: a) Funded Public Debt ia a long term debt done by the government for the period of 10 to 20 years or even more. b) Funded Public Debt is done for the creation of some permanent assets like construction of roads, railway lines, bridges, dams etc. B. Unfunded Public Debt: Unfunded Public Debt is a short term debt by the government for the period of one year or less than a year. Unfunded Public Debt is done to meet temporary needs of the government. 4) Redeemable and Irredeemable Public Debt. The Public Debt on the basis of maturity is classified into two categories. They are as follows: A. Redeemable Public Debt . B. Irredeemable Public Debt. A. Redeemable Public Debt: Redeemable Public debt is the debt which government promises to repay at some specific future date. Redeemable Public Debt is terminated after the expiry of maturity period. Hence they are also called as terminable loans.

a) b)

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B. Irredeemable Public Debt: a) Irredeemable Public Debt are the debt in which no promises is made by the government regarding the exact date of maturity but the government continues to pay interest on them. b) Irredeemable Public Debt is not terminated as their maturity period is not fixed .Hence they are also referred to as Non-terminable loans. 5) Compulsory and Voluntary Public Debt The public debt on the basis of use of force by the government is classified into categories. They are as follows: A. Compulsory public Debt. B. Voluntary Public Debt. A. Compulsory Public Debt: a) Compulsory public debt refers to the borrowing done by the government by applying some force. b) Compulsory public debt is done by the government during financial emergency or exceptional circumstances like war. B. Voluntary Public Debt. a) Voluntary Public Debt are done by the government on voluntary basis by inviting general public and final institution to subscribe to the bonds issued by the government b) Voluntary Public Debt is generally done in a democratic country during normal times to finance various activities of the government. Q3.b. Discuss the burden of internal & external Public debt? Ans: Public Debt is a financial obligation or liability of the government. The amount borrowed has to be repaid with specified rate of interest. Thus public debt creates burden on the nation. The burden of public debt can be further classified into two categories. They are as follows: A. Burden of Internal Debt. B. Burden of External Debt. A. Burden of Internal Debt: The burden involved in case of Internal Public Debt are as follows: 1) Widens Gap between Rich & Poor: Generally the richer section of the society invests in government securities. When government repays the loan to holders of these securities by imposing heavy taxes there is a transfer of purchasing power from poorer sections of the society to the richer sections of the society. This further widens the gap between richer & poorer section of the society. 2) Adverse Effect on the Productive Capacity of the Economy:

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When the government impose heavy taxes to repay public debt it reduces the ability and desire of people to work, save & invest. This further leads to a decline in the productive capacity of the economy. Transfer of Purchasing power from Younger to Older Generation: Generally bond holders are the old people and the taxes are paid by the younger generation. When government repays public debt by imposing heavy taxes there is a transfer of purchasing power from younger generation to older generation. The ability and desire to work, save and invest of younger generation may also be significantly reduced in the economy. Increase in Real burden of War Financing: When government borrows during war the prices are high and the value of debt is loan real terms. The government repays the loan after war when the prices are low and the value of debt is high in real terms. Thus internal debt done to finance a war increases real burden of debt. Reduces Private Investment: When the government borrows from general Public and financial institutions the amount of fund available to private sector falls. This would further result in rise in rate of interest and fall in volume of private investment in the economy. Burden of External Debt: The external debt done from foreign countries and world financial institutions. They are certainly more burdensome than internal public debt. The burdens involved in case of external public debt are as follows: Direct Money Burden: The external public debt involves direct money burden on debt or country. The direct money burden constitutes the money burden on account of payment of interest and the Principal amount. Direct Real Burden: When government imposes heavy taxes to repay the loan it reduces the consumption of power and weaker section of the society. Thus the external debt also results in direct real burden on the poor people of the country. Indirect Burden: The external debt also creates indirect money and real burden on nation. The payment of external debt results in reduction in public expenditure of the government. The fall in public expenditure further reduces the volume of investment, output and employment in the country. Export of Essential Commodities: The repayment of external debt is done in foreign currency. The external debt becomes more burdensome when the repayment is done by the government by increasing exports of essential commodities. The export of essential commodities creates scarcity in domestic economy and the prices of essential commodities shoots up to a very high level. The sharp rise in prices further create severe hardship and suffering to poorer and weaker section of the society. Loss of Economic Sovereignty: Generally the advanced countries while granting loan to poor countries imposes various terms and conditions to be followed by poor countries. The advanced countries sometimes even force

the poor countries to change their economic policies in their favour. Thus the external debt results in loss of economic sovereignty to poor countries and poor countries may just become puppet in the hands of rich countries. Q.4a. Explain the concepts of Deficits? Ans: The word deficit refers to the gap between income and expenditure of the government. The various concepts of deficit used in budget in modern world are as follows: Revenue Deficit Budgetary Deficit Fiscal Deficit Primary Deficit 1) Revenue Deficit: The deficit in revenue account of the budget is called as Revenue deficit. It refers to the excess of revenue expenditure over the receipts of the government. Revenue deficit reflects the inability of the government to finance current expenses through tax and non-tax revenues 2) Budgetary Deficit: It refers to the excess of total expenditure over total receipt of the government. The Budgetary deficit in India is met by either withdrawing cash balances kept with R.B.I or by net addition to the treasury bills issued by the central government. It is only a partial measure of budgetary imbalances as it does not reflect the total indebtechness of the government. 3) Fiscal Policy: It refers to the excess of total expenditure over total receipts, excluding borrowing and other liabilities. It shows the total resource gap in the financial operation of the government. It is a comprehensive measure of budgetary imbalances as it fully reflects the total indebtechness of the government. 4) Primary Deficit: It refers to the deficit obtained by subtracting interest payments from fiscal deficit. It is also referred to as non-interest fiscal deficit. It reflects burden of interest payments on nation. Trends in deficit in Indian during the period 1990-91 to 2009-10. The trends in various types of deficit in Indian during post-reform period 1990-91 to 2008-09 can be clearly explained with the help of following table:

1) 2) 3) 4) a) b) c)

a) b) c)

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Year Revenue deficit Fiscal Deficit Primary Deficit 1990-91 3.3 6.6 2.8 2009-10(Provisional) 5.1 6.3 3.1 Central Government Deficit (As % of GDP at current Market Prices) during the period 1990-91 to 2009-10 Source: Economic Survey 2010-11 page 45 It is clear in above table that: 1) The Revenue Deficit has increased from 3.3% of GDP in 1990-91 to 5.1% of GDP in 2009-10.This is a dangerous trend in Indian economy 2) The situation in Revenue Deficit has deteriorated due to decline in Revenue receipts and sharp rise in Revenue expenditure of the central government. 3) The Revenue Expenditure of the central government was 12.9% of GDP in 199-91 which has declined to 13.9% of GDP in 2009-10. 4) The Revenue Receipts of the Central Government was 9.7% of GDP in 1990-91 which has declined to 8.8% of GDP in 2009-10. 5) The Fiscal Deficit of the government indicates some improvement during post-reform period. The Fiscal deficit declined from 6.6% of GDP in 1990-91 to 6.3% of GDP in 2009-10. 6) The Fiscal Deficit has declined during post-reform period due to some important measures taken by Government to control deficit. They are as follows: a) The export subsidies have been abolished. b) There was a complete ban on recruitment and surplus staff was removed. c) The capital expenditure was drastically reduced during the period 1990-91 to 2009-10. d) The food subsidies were drastically reduced to Above Poverty Line(APL) families. 7) The Primary Deficit situation shows some improvement during post-reform period.The Primary Deficit which was 2.8% of GDP in 1990-91 has increased to 3.1% of GDP in 2009-10. 8) Primary Deficit refers to the difference between fiscal deficit and interest payments. Thus the rise in primary deficit indicates the fall in burden of interest payment during the period 1990-91 to 2009-10. 9) The burden of interest payment in India during the year 1990-91 was 3.8% of GDP which has declined to 3.2% of GDP during the year 2009-10. Conclusion: It is clear from above that the situation of deficit in Central government budget is not encouraging. The sharp rise in revenue deficit and mearge fall in fiscal deficit during the period 1990-91 to 2009-10 should be an alarming signal to Indian economy

Q.4b. Explain the provisions of FRBM Act 2003. Ans. The fiscal Responsibility and Budget Management Bill 2000 became an Act after receiving the assent of the president in August 2003. The main features of Fiscal Responsibilty and Budget Management Act 2003 which became effective from July 5, 2004 are as follows: 1) Reduction in Revenue Deficit: The first important feature of FRBM Act 2003 is that the central government should take certain specific measures related with reduction of revenue deficit. They are as follows: The government should reduce revenue deficit by an amount equivalent to 0.5 percent or more of the GDP at the end of each financial year, beginning with 2004-2005. The revenue deficit should be reduced to zero within a period of five years ending on March 31, 2009. Once revenue deficit becomes zero the central government should build up surplus amount of revenue which it may utilized for discharging liabilities in excess of assets. 2) Reduction in Fiscal Deficit: The second important features of FRBM Act2003 are that the central government should take certain specific measures related with reduction of fiscal deficit. They are as follows: The central government should reduce Gross fiscal deficit by an amount equivalent to 0.3percent or more of the GDP at the end financial year, beginning with 2004-2005. The central government should reduce Gross fiscal deficit to an amount equivalent to 3 percent of GDP up to March 31, 2009. 3) Exceptional grounds: The third important feature of FRBM Act 2003 is that is clearly stated that the revenue deficit and fiscal deficit of the government may exceed the targets specified in the rules only on the grounds of national security or national calamity faced by the country. 4) Reduction in Public debt: The fourth important features of FRBM Act 2003 that the central government should not incur any additional liabilities including external debt at current exchange rate in excess of 9% of GDP for the financial year 2004-05. There should be progressive reduction of this limit by at least one percentage point of GDP in each subsequent year. 5) Borrowing from R.B.I: The fifth important feature of FRBM Act 2003are related with borrowings done by central government from the R.B.I The FRBM Act 2003 clearly states that the central government shall not normally borrow from the R.B.I. However the central government may borrow from R.B.I. by way of advances to meet temporary year in accordance with the agreements which may either into by the government with R.B.I. 6) Limit of Guarantee: The sixth important features of FRBM Act 2003 are that it restricts the guarantees given by the central government to 0.5% of GDP in any financial year beginning with 2004-05

a) b) c)

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7) Compliance of Rules: Finally the ninth important features of FRBM Act 2003 are related with measures to enforce compliance of rules. These measures are as follows: a) The central government should review every quarter the trends in receipts and expenditures in relation with budget. b) The central government should take appropriate actions in case of revenue and fiscal deficits exceeding 45% of budget estimates at the end of first half of the financial year. Conclusion: The above features Fiscal Responsibility and Budget Management Act 2003 clearly points out that the government intends to create a strong institutional mechanism to restore fiscal discipline at the level of the central government. Similarly the government wants to introduce greater transparency in the fiscal operations of central government.
Q5. Explain gains from International trade? Ans Gains from international trade are as follows:INCREASE IN WORLD PRODUCTION :- Each country specialises in the production of those commodities for which it is better suited in terms of cost of production. If a country attempts to produce everything what it requires then it may do so at a higher cost and lower production. International trade which is based on international division of labour leads to more production due to specialization for e.g. The total production of both countries is 40cloth & 24 machines, a sum total of 64 units. India, as we can see has a comparative advantage in the production of cloth and U.S.A in machines. Ih they go for complete specialization applying the labour for producing only one commodity. Then india will produce 40 units of cloth and U.S.A 40 units of machines, a sum of total 80 units. India - 40 units of cloth U.S.A - 40 units of machines Total = 80 units INCREASE IN CONSUMPTION :- With the increase in production as discussed earlier, the increase in consumption of the people of the countries which participate in international trade would also increases. Such positive changes enhance the economic welfare of the people. Following diagram explains the change in consumption and gain from trade.

HIGHER ECONOMIC WELFARE :- International trade, results in increased production due to specialization.As discussed earlier, trade results in addition production and consumption. The gains in terms of welfare before and after trade can be explained with the help of figure A & B.

GAINS ON THE BASIS OF RECIPROCAL DEMAND :- It is the strength and elasticity of one countrys demand for the other countrys commodity in exchange for its own goods at different price ratios of exports and imports (terms of trade).Reciprocal demand is expressed in terms of offer curves. An offer curve is a graphical representation of reciprocal demand indicating various quantities of imports at a succession of possible terms of trade. In the following diagram Indias offer curve OI and Russias offer curve OR. The diagram explains the domestic rate of exchange, international terms of trade and gains from trade.

Q.6. Define balance of payments? Explain the structure of balance of payments? Ans: Balance of payment of a country is defined as Systematic record of all economic transaction between the resident of a country and the rest of the world during a given period of time usually a year. The balance of payments accounting of any country uses double entry system of recording accounts with rest of the world. All international transactions which results in payments are recorded as debit entries and similarly all international transaction which results in receipts are recorded as credit entries in balance of payment account. Structure of balance of payments There are two main components of balance of payments account. They are follows: A) Current Account B) Capital Account A) Current Account The current account of the balance of payments include following items: 1) Export and import of goods which are also referred as tangible or visible export and import. The difference between export and import of good is called as Trade Balance. 2) Export and import of services which also referred to as invisibles. The services include Banking, insurance, transport, tourism etc. It is called as Balance of invisible trade. 3) Income from investment in foreign countries and payment for investment done by foreign countries in form of interest, profit, dividend etc. 4) Unilateral receipt and payment which include gifts, donations etc. Such receipts and payments are given and received free without any obligation to repay. B) Capital Account: The capital account of the balance of payment include following items: 1) Foreign investment and investment abroad.

The foreign investment includes two main items. They are as follows: A. Direct Investment B. Portfolio Investment A) Direct Investment: It refers to acquisition of income generating asset in foreign country. It includes the establishment of new plant, a takeover or merger or joint venture projects undertaken by multinationals. B) Portfolio Investment: It refers to acquisition of financial asset in foreign countries. It includes purchase of shares of foreign company, bonds issued by foreign countries and investment in bank deposits. 2) Short term borrowing and short term lending: The short term borrowing is done to cover up deficits in current account. It is generally done for a period of five years or less than five years. 3) Long term borrowing and long term lending: The long term borrowing is done generally for more than five years from the government of other countries and international financial institutions like I.M.F. If all entries in balance of payment account are made correctly then the total credits must equal the total debits. Thus the balance of payment always balance in accounting sence. The difference between Receipts and Payments in current account is called as Current Account Balance. The difference between the receipts and payment in Capital account is called as capital account balance. Q.7a.What are the types of Disequilibrium in the balance of payment? Ans: Disequilibrium in the balance of payment refers to a situation of either deficits or surplus in balance in payment. There are different types of disequilibrium in balance of payment. They are as follows: 1. Cyclical disequilibrium in balance of payment: a) Cyclical disequilibrium in balance of payment ie caused due to cyclical changes in economic activities in different countries of world. b) There may be fluctuation in domestic economic activities. The prosperity period in domestic economy raises income and prices. This would further result in increase in import without any significant change in export. Thus deficit is created in balance of payment during prosperity period.

c) There may be period of recession or depression in domestic economy which would reduce price and income. The fall in income would reduce import and fall in price would increase export. Thus a surplus is created in balance of payment due to period depression in economic activities. d) The fluctuation in international economic activities also causes cyclical disequilibrium. For example the recession in USA would hit export of India and would increase export of India and would result in surplus in balance of payment. 2) Structural disequilibrium in balance of payment: a) It is caused by the structural changes at home or abroad which effects either Export or Import or both. b) When the demand for natural raw material like jute declines abroad due to introduction of synthetic substitutes the exports of developing countries like India falls. The sharp decline in exports with imports remaining same creates disequilibrium in balance of payments. c) When the supply of labor changes in factor market it affects factor prices which may further affect commodity prices. For example the shortage of labor in factor market would result in sharp rise in factor prices. The rise in factor prices would result in sharp rise in commodity price. This sharp rise in prices may severely hit export of a country and would create disequilibrium in balance of payment. 3) Short run disequilibrium in balance of payment: a) Short run disequilibrium in balance of payment is a temporary disequilibrium in balance of payment caused due to domestic problem like failure of monsoon, natural calamities or political disturbance which may suddenly increase the imports or may result in sharp decline in exports. b) Short term disequilibrium do not require any major policy measures. They can be corrected through short term borrowings by the government from IMF. 4) Long run disequilibrium in balance of payments: a) Long run disequilibrium is disequilibrium in balance of payment which is deep rooted in continues to exist for a long period of time. b) Long run disequilibrium in balance of payment is caused due to continuous excess of imports over exports. It is termed by IMF as fundamental disequilibrium in balance of payment c) Long run disequilibrium in balance of payment requires major policy measures by the government to increase export and reduce import to correct disequilibrium in balance of payment. 5) Exchange rate disequilibrium in balance of payment: a) Exchange rate disequilibrium is a normal phenomenon in a world of controlled foreign exchange. It is caused either due to overvaluation or undervaluation of currency. b) The overvaluation of currency makes foreign products relatively cheaper and domestic goods costlier in foreign market. This would increase imports and would reduce export. Thus overvaluation of currency tends to create deficit in balance of payment.

c) The undervaluation of currency makes foreign product relatively costlier and domestic product relatively cheaper in foreign market. This would increase export and would reduce imports. The undervaluation tends to create a surplus in balance of payment. Q.7b. Explain methods to correct disequilibrium in the balance of payments? Ans. The measures to correct disequilibrium in balance of payment can be broadly divided into two categories. They are as follows: A) Monetary measures to correct disequilibrium on balance of payment B) Non-monetary measures to correct disequilibrium on balance of payments. A) Monetary measures to correct disequilibrium on balance of payment: The monetary measures taken by the central bank to correct disequilibrium in balance of payment are as follows: 1) Deflation expenditure adjustment: a) Under this method the central bank reduces money supply by following contractionary monetary policy. The contraction in money supply further results in fall in prices. The fall in prices helps to increase exports and reduce imports. Thus a deficit in balance of payments gets corrected due to deflationary monetary policy adopted by the government. b) Deflation leads to expenditure adjustment as the people in a country spend mainly on domestic goods and services and less on imports. Deflation however is not a advisable policy measure in modern world as it tries to reduce deficit in balance of payment at the cost internal growth and achievement of high level of employment in the country. c) Deflation may also create problem of reduction in money wages of working class. This would result in labor unrest throughout the country. 2) Exchange control: This is another measure used by the central bank to correct disequilibrium in balance of payment. Under this method the central bank directly controls all the foreign exchange transactions of the country. The exporters are required to surrender their foreign exchange to the central band which makes foreign exchange available for the purpose of imports to importers in accordance with the priorities of nation. 3) Devaluation- Expenditure switching: a) Devaluation of currency means lowering of external value of home currency in term of other currencies of world by the government authorities. b) There is a difference in the term Depreciation of currency and Devaluation of currency. The term depreciation of currency refers to the automatic reduction in external value of home currency by market forces while the term devaluation refers to the official reduction in external value of home currency in relation with another currency of the world.

c) Devaluation is the most commonly used method by central bank to correct disequilibrium in balance of payment. The devaluation of currency makes export cheaper and import costlier. Thus devaluation increases exports and reduces imports and makes balance of payment situation favorable to a country. d) Both devaluation and depreciation method results in expenditure switching. The people switch or divert the expenditure from their goods to the goods of the country which devalued its currency or whose currency is depreciated as they are now cheaper than their own domestic goods. These further results in rise in exports and fall in imports of the devaluing country. e) Though disequilibrium is an important measure to correct disequilibrium in balance of payment it success or effectiveness depends upon various factors. They are as follows: 1) Elastic demand for exports and imports: devaluation can be successful only if demand for export and import is elastic. Inelastic demand will worsen the balance of payment by high value export and low value import. 2) Domestic price stability: Devaluation would be successful only if the price level inside the country remains same. If the domestic price level rises due to change in cost structure the whole purpose of devaluation will be defeated. 3) Structure of exports: Devaluation would be successful only if the developing countries change its structure of exports from traditional items which have huge demand in foreign market. 4) International cooperation: Devaluation would be successful only if other countries dont retaliate with the devaluation of their own currency. The cooperation of other countries is essential so that beneficial effect of devaluation is not nullified. 5) Coordination with other measures: If devaluation is backed by other measures like hike in import duties, incentives for exports etc it would be successful in correcting disequilibrium in balance of payment. B) Non Monetary measures or Direct measures to correct disequilibrium in balance of payment: The non monetary measures used by government are as follows: 1) Tariff: a) Tariffs are the duties levied on imports. When government imposes high tariff on imported commodities they become costlier. This leads to fall in demand for imports. Thus the decline in imports with exports remaining same helps to correct disequilibrium in balance of payments. b) Limitations: Tariff may not be effective if demand for import is inelastic. It may not be effective if other countries retaliate by increasing their import duties. Corruption among administrative staff in number of developing countries would make tariff ineffective. Tariff has limited role at present as the world is moving towards gradual reduction in tariff under WTO regime. 2) Quotas: a) It refers to quantitative restrictions in volume of exports. Under Quotas system the government fixes the quota for imports during a specific period of time.

b) Quotas have an immediate effect in restricting imports as imports are not allowed to exceed the fixed quota. The fall in imports with exports remaining same further helps to correct disequilibrium in balance of payment. c) Though Quota are better than tariff as they are more certain and flexible they have limited role in modern world to correct disequilibrium in balance of payment. The quota system has been discouraged under WTO regime and has been abolished by large number of countries of the world. 3) Import Substitution: Another important non monetary measure used to correct disequilibrium in balance of payment is to encourage import substitution industries to reduce quality of imports. The government initially provides various tax concessions subsides, technical assistance to encourage import substituting industries to grow. The reduction in imports due to import substitution while exports remaining same helps to correct disequilibrium in balance of payment. 4) Export Promotion: The export promotion is a program by the government to boost export. The government may provide various incentives like tax concessions cheap credit and marketing facilities, export subsidies etc to encourage exporters to boost export. The increase in export earning with import remaining same further helps to correct disequilibrium in balance of payment. Q.8a .Explain with a gap price effect of a quota to correct disequilibrium in BOP? Under the quota system, the government may fix and permit the maximum quantity or value of a commodity to be imported during a given period. By restricting imports through the quota system, the deficit is reduced and the balance of payments position is improved. Types of Quotas:the tariff or custom quota, the unilateral quota, the bilateral quota, the mixing quota, and import licensing

1. 2. 3. 4. 5.

Q.8b. Explain effect of a Tariff using simple D.Surve? Diagrammatic Illustration of Effects of Tariff Figure illustrates the consumption, protective, revenue and redistributive effects of tariff. DD1 is the domestic demand curve and SS1 the domestic supply curve. In the absence of foreign trade the equilibrium price is P2, domestic demand and supply being Q4 For simplicity, we assume that the foreign supply is perfectly elastic at price P, Therefore, under free trade the supply position is represented by PF.

Under free trade, at price P the total domestic demand is Q; Q2 of which is met by domestic supply and Q2 Q is imported. Now, assume that the government imposes a tariff of PP1 per unit of import so that the price rises from P to P1 Consequent upon the increase-in price, the total domestic demand falls to Q1 The increase in price enables the domestic supply to increase from Q2 to Q1 The remaining part of the domestic demand (Q3 Q1) is met by import. Under free trade, the total consumers' surplus is DPF but with the tariff it is reduced to DPI F1; the total loss of consumers' surplus being P1 PFF1. This loss to consumers is absorbed in a number of ways. When the tariff per unit is PP1, the total imports is Q3 Q1. Therefore, government gets tariff revenue equivalent to ABCF 1 (PP j x Q3 Q 1).This is the revenue effect of the tariff. At the higher, tariff imposed, price, the producers get an additional return of

Fig. Effect of tariff PP1 on every unit. As the supply curve also represents the cost curve, the total gain to the producers due to the imposition of the tariff is PP1 AE. This additional economic rent to the producers represents a transfer of income from the consumers to the producers. This is the redistributive effect of the tariff. Protection enables the domestic producers to increase supply from Q2 to Q3' ABE represents the sum of the additional cost per unit of output. This is the protective effect of the tariff.

Due to the increase in price as a result of the protection. Consumption has fallen from Q to Q1 causing a loss of consumers' surplus by C FF1: This is the consumption effect of the tariff. It must be noted that part of the loss of the consumer surplus represented by the revenue effect and the redistribution effect are gained by the government and the producers. Hence they do not represent a loss to the economy; they represent transfer of income from one sector to other sectors within the economy. Hence the total net loss imposed by the tariff upon the economy is thus a sum of the protective effect and the consumption effect (ABE + CFF1). The effect of tariff on terms of trade can be illustrated with the help of offer curves. In Fig. OH is the offer curve of the home country exporting X goods and importing Y goods and OF is the offer curve of the foreign country exporting

Fig. Effect of tariff on terms of trade Y goods and importing X goods. The free trade equilibrium terms of trade is represented by the slope of OT. Q.9.Explain the emerging trends in Indias balance of payments position since 1991? Published By admin under Uncategorized Tags: balance, balance payments position since, emerging, emerging trends, explain, explain-the-emerging, explains, explain_the_emerging, india, indias balance, indias balance payments, indias balance payments position, indias balance payments position since, indias balance payments position since 1991, payment, payment position, payments, payments position, payments position since 1991, position, since 1991, trends-in-india, trends-in-indias, trends in Indias new trends in Indian BALANCE payments position since 1991. INTRODUCTION: Balance India in the payments position showed

different cyclic changes from the first five-year plan(1951-52) The first five plan was the only period in which there are no problems with the balance of payments position From the second five-year plan, India withessed problems of varying intensity, as reflected in the balance of payments position, and by the end of 1980, the situation has reached critical point. Account deficit was trading 3.2% of GDP, while the deficit on current account storl at 2.2%. deficit was financed by resorting to commercial loans. Introduction: Crisis and Recovery(1990) CRISIS:. Gulf crisis in 1990 led to a negative impact on the already worse balance of payments position, while the current account deficit rose to 3.1% of GDP in 1990-91 foreign exchange reserves fell also began to decline from 3.1 billion in August 1990 for $896 million in January 1991 So, the government had to resort to the IMF to overcome balance of payments position In June 1991, the payment default has become a serious possibility for the first time in the history of India. It became a crisis of confidence in the Government's ability to manage the balance of payments position. RECOVERY: In June 1991 a new government headed by Mr PV Narsimha Rao with Dr. Man MohanSingh as finance minister and Mr P. Chidambaram as commerce minister for a number of measures for macroeconomic stabilization and structural reforms in industrial policy and trade. There was also no adjustment made in the exchange rate. These measures gradually stabilizing the balance of payments position and to restore international confidence. In the year 1991-1992 ended with the current account deficit below 1% of GDP. India's balance of payments position in 1991: Balance of payments position may be reflected from: Trade balance Current account balance Capital account balance Foreign exchange reserves Trade balance: The trade balance has always been a deficit, as imports always exceeded exports. Here are details on the trade deficit: 1990-1991: us $9,438,000,000 2000-01: us $12.46 billion 2008 -09: us $118,650,000,000 Current account balance: Current account includes(i) does not factor in services such as travel, transportation, insurance, financial services, communications, business services, software services(IT and IT enabled services), ii revenues) in the form of dividends and interest from investments abroad, iii) private transfers and iv) official transfers our current account balance also always shown a deficit except for the years 2001-02, 2002-03 and 2003-04. However, revenue from services other than factor played an important role in reducing the current account deficit. Here is the current account deficit: 1990-1991: us $9.68 billion 2000-01:. Us $2666000000 2008-09: us $28.728 billion Capital Account Balance: The deficit on current account is governed by the influence capital account or by reducing the foreign exchange reserves. External aid and repayment of IMF loans have finally become zero, while commercial loans on the rise. foreign investment in the form of FDI and FIIs were always positive. us $103 million from 1990 to 1991 2007-08: us $- 43326000000 2008-09: us $3.467 billion Capital account balance was not always positive after covering the current account deficit, the excess is added to reserves. However, when current account deficits are larger than the surplus on capital Account, foreign exchange reserves are also used to cover these deficits. reserves: India's exchange reserves are held in the form of foreign currency assets(FCAS), gold, special drawing rights(SDR) and reserve tranche position( RTP), the International Monetary Fund.(IMF). Through the intervention of the RBI is the flow rate may be brought or absorbed from the market. foreign currency assets are held in the form of a dollar, pound sterling euro, Australian dollar, Japanese yen, etc. However, foreign exchange reserves are denominated in U.S. dollars only. Foreign exchange reserves were as follows: 1991: $5.8 billion 1995: $25.2 billion 2008: $314.6 billion (March) 2009: $252.0 billion (December 2009): 283 500 000 000 U.S. dollar REASON for the deficit in India's BOP position: valid reasons BOP deficit position in India may be cited as follows: i) growth of imports: import growth is the most important factor for the

deficit in the balance of payments position of India. India's imports increased significantly from $27.915 billion(1990-91) to $307.651 billion(2008-09) Import mainly consisted of: Capital goods(initially for industrialization and modernization, and later on technology upgradation) Cereals edible oils(the main element in imports) cause a rapid increase in imports of building an industrial base(in the initial phase), growth of export-related imports(stones, jewelry, capital goods), the increase in imports of industrial raw materials, rising prices and the import of POL products, etc. ii) the devaluation of the rupee and DEPRECIATION devaluation of the rupee and DEPRECIATION led to an increase in import prices Exports have become cheaper, low price and income elasticity of demand export-led to slow growth in exports. iii) the slow growth of export earnings: Export earnings have increased, but they were not sufficient to meet the growing imports. Thus, export growth has been neither significant nor permanent. Export growth is not sufficient to finance imports is growing. iv) Competition from other countries: India export earning increased, but they were not sufficient to meet the growing imports. India exports affected by competition from other countries like the Philippines, Indonesia, Malaysia, Latin America and Africa. Recently China has become the major competitors. v) Debt Service: balance of payments problem is also worsened due to increasing commitments ammortisation payments in 2008-09, debt service ratio was 4.4 % with history an increase in imports and slow exports, the most effective solution for the balance of payments problem in India is to reduce costs and competitiveness in the global warket. iv) Gratitude: recent appreciation of rupee has made exports more expensive and imports cheaper. This may also contribute to the balance of payments problem. INDICATORS balance is There are many indicators that bring out the strengths and weaknesses of a country's balance of payments. include: i) the ratio of exports and imports in% BOP: 1990-91: $66,200,000 2003-04: $82,900,000 2008-09: $61,400,000 Although imports and exports do not increase, rise always import more than export growth. ii) cover the import of foreign exchange reserves(FER): 1990 to 1991: 2.5 months 2003-04: 16 9 months 2008-09: 9.8 months global economic recession(2007-2009) reduced foreign exchange reserves. But in September 2009 was to improve the situation as an import cover of FER increased to 12.4 months. iii) the flow of debt: flow of debt capital account, consisting of NR deposits, external commercial borrowings and external aid has increased. This is not a very encouraging sign. iv) External debt: 1990-91: 28.7% 2008-2009: 20.5% indicates a decrease of foreign debt, reduce dependence on foreign countries and institutions. The global economic crisis(2007-09) relates to a lesser extent India, because of the domiciled Indian economy. Translate for Toolkit Global Market Finder Website Translator About Google Translate Turn off instant translation. Q.10) Short notes on (A)Function of WTO 1.The WTO facilitates the implementation, administration and operation, and furthers the objectives, of this Agreement and the Multilateral Trade Agreements, and also provide framework for the implementation, administration and operation of the Plurilateral Trade Agreements. 2. The WTO provides the forum for negotiations among its members concerning their multilateral trade relations in matters dealt with under the agreements and a framework for the implementation of the results of such negotiations, as may be decided by the Ministerial Conference. 3. The WTO administers the Understandings on Rules and Procedures governing the Settlement of Disputes.

4. The WTO administers the Trade Policy Review Mechanism (TPRM). 5. With a view to achieving greater coherence in global economic policy-making, the WTO cooperates as appropriate, with the International Monetary Fund (IMF) and with the International Bank for Reconstruction and Development (World Bank) and its affiliate agencies. (B)TRIPS,TRIMS,GATS TRIPS The areas of intellectual property that it covers are: copyright and related rights (i.e. the rights of performers, producers of sound recordings and broadcasting organizations); trademarks including service marks; geographical indications including appellations of origin; industrial designs; patents including the protection of new varieties of plants; the layout-designs of integrated circuits; and undisclosed information including trade secrets and test data. TRIMS The Agreement on Trade Related Investment Measures (TRIMs) are rules that apply to the domestic regulations a country applies to foreign investors, often as part of an industrial policy. The agreement was agreed upon by all members of the World Trade Organization. (The WTO wasn't established at that time, it was his predecessor, the GATT (General Agreement on Trade and Tariffs). The WTO came about in 1994-1995. Policies such as local content requirements and trade balancing rules that have traditionally been used to both promote the interests of domestic industries and combat restrictive business practices are now banned. Trade Related Investment Measures is the name of one of the four principal legal agreements of the WTO trade treaty. TRIMs are rules that restrict preference of domestic firms and thereby enable international firms to operate more easily within foreign markets. GATS The General Agreement on Trade in Services (GATS) is a treaty of the World Trade Organization (WTO) that entered into force in January 1995 as a result of the Uruguay Round negotiations. The treaty was created to extend the multilateral trading system to service sector, in the same way the General Agreement on Tariffs and Trade (GATT) provides such a system for merchandise trade. All members of the WTO are signatories to the GATS. The basic WTO principle of most favoured nation (MFN) applies to GATS as well. However, upon accession, Members may introduce temporary

Q.11a. Explain the objective and function of WTO? Objective of World Trade Organization (WTO) * To ensure the conduct the international trade on non-discrimination basis. * To raise standard of living and income, ensuring full employment * To expend production and trade * Protecting environment * Ensuring better share for developing countries. FUNCTION OF WTO

Among the various functions of the WTO, these are regarded by analysts as the most important: It oversees the implementation, administration and operation of the covered agreements. It provides a forum for negotiations and for settling disputes. Additionally, it is the WTO's duty to review and propagate the national trade policies, and to ensure the coherence and transparency of trade policies through surveillance in global economic policy-making. Another priority of the WTO is the assistance of developing, least-developed and low-income countries in transition to adjust to WTO rules and disciplines through technical cooperation and training. The WTO is also a center of economic research and analysis: regular assessments of the global trade picture in its annual publications and research reports on specific topics are produced by the organization. Finally, the WTO cooperates closely with the two other components of the Bretton Woods system, the IMF and the World Bank. Q11b. Examine the impact of WTO on Indian economy? The World Trade Employer Came to be earned to use all of the Facets of On the subject off trade slow progress done Very much arriving at the effects Connect on Indias overseas trade But also because of on The inner economy. The impact of the WTO on the Indian economy is actually analyzed on the schedule and as a consequence all round concepts. The WTO Has got often favorable and even non-favorable affect the Indian economy. FAVOURABLE IMPACT: 1) Escalating export incomes: Increase in export takings can be looked at Because of development in items exports not to mention development in Company exports:

Development in object exports: The store of the WTO has grown the exports of Solutions achievable for lowering mobile phone deal And therefore non-tariff trade barriers. Indias product exports Use Sperm enhancement pills of 33 million our needs $ (1995) which will 185 million Ough $ (2008-09). Development in In-lab service exports: The WTO devices have been the GATS (general Contract on Trade in Businesses) which explain why attest therapeutic for high quality Love India. Indias Plug-in exports Used spermomax on step 5 thousand Our business $ (1995) Assist 102 thousand Them $ (2008-09) (software Sites accounted) Because 45f Indias Provider exports) Law care export Reduction of trade hindrances and after that at-home tax assistance boost the expense of lawn Resources in Known as market, India wants that can work with this one as more export paycheck originally from agriculture Textiles As well as the Attire: The phasing Right out the MFA Most certainly mainly profits the textiles sector.

It will make the Useful along with the kind of India Optimize the export of textiles and after that clothing. Currency One-on-one Investment funds: As single the TRIMs agreement, limits on currency Business seem to have been removed a variety of registrant Americas of the WTO. This Gives you benefited Gaining that may by means of overseas Channel investment, euro equities and make sure to Accounts investment. In 2008-09, Websites dangerous 1 on 1expenditure of money in India Am thirty-five thousand Bellies $. Multi-lateral Protocols and after that Regime: It is believed The fact Non-discriminatory trade variables being created, Companies Guidelines And as well as Practice resulting from clinics Love anti-dumping, financial assistance Coupled with countervailing measure, safeguards And as well dispute settlements. Such circumstance Are likely to Desirability India In the seek to globalize looking at videos economy.

UNFAVOURABLE IMPACT: 1) TRIPs Protection of rational Building privileges can be One of the leading uncertainties of the WTO. As a within WTO, India ought to keep in mind the jaunts standards. However, the Arrangement on excursions proceeds about the Indian patent act, 1970, Included in the Ensuing ways: Pharmaceutical drug field: Under the Indian Patent act, 1970, Alone Job patents are actually Comfort. To be able to chemicals, medication then medicines. Thus, Landscaping design Will likely cyber casino games Production Recall This tool found the cell phone batteries patent. So Indian Prescription Businesses are able to give reliable Treatments (medicines) at Expense prices. However biting holidays agreement, Items patents are likewise Awarded that you can grow up The costs of medicines, Income Approaches personal computer above make of the restoring people, fortunately, Quite a bit detrimental drugs constructed in India Will most certainly be in places you can -patents Therefore is undoubtedly not as much affected. Agriculture Since the Arrangement on clicks reaches Farming Even as well, It is going to End up with volume implications on Indian agriculture. The MNG, Because of their usefulness Amazing Confront resources, might Transport On top of seed Assembly and may Inevitably Limit The food they eat production. Since a sizable Might be amazed Indian residents will be able to Farming with regard to livelihood, Persons general trends will provide Severe consequences.

2) TRIMS: The Long term contract on TRIMs Ins created economies and there is no Come with Covered in the Decision To assist you to produce Concerning In addition to In order for primary Operation behavior of unfamiliar investors. Also, complying Utilizing TRIMs Statement Also contradict A function of personally dependent Overgrowth using in the community available to buy Machinery And thus resources. 3) GATS: The Decision on GATS results in improving favor the civilized economies more. Thus, the speedily steadily building Activation time arena in India can really need to devices larger unfamiliar firms. Moreover, Battery pack unusual They ought to can remit Bar owners profits, rewards Furthermore royalties thus to their Father or mother company, Too. Underlying cause mysterious Substitute problem At India. 4) TRADE Combined with not for mobile phone deal dams: Reduction of trade In addition to non-tariff secure fencing Enjoys detrimentally reduced the exports of Distinct Initiating nations. Various Indian May well be Press by. Non- mobile phone deal barriers. Visit your doctor if textiles, sea products, floriculture, pharmaceuticals, basmati rice, carpets, fresh dampened Items you ordered etc. 5) LDC Exports: Many representative lands Keep opted for Deliver challenge force Plus quota force Arena To access Strategies Some risk Crap ! With the minimum improved countries. India needs to look at More fashionable endure the detrimental sense of competitions Suffering from Low price LDC exports internationally. Moreover, LDC exports additionally normally Indian Current market thereby smart phone market domestically originated goods. Consideration: Thus the WTO is often a useful method that was designed to enact Relating to Protocols on Distinctive important things. It may globalize quite a few high quality And also Make this happen in order to produce The availability of fair Strengths And additionally Test Positive aspects For Intricate Systems of Alternative nations. Though locations Wish India Have the ability to surface Life-threatening Struggles Generally complying Of the WTO agreements, A bonus need It all anyone can improve of an Living Dealing with environment. Q.12a. Changes in Exchange Rate? The equilibrium exchange rate is determined by the intersection of demand for and supply of foreign exchange. At this point the demand is equal to supply. However the demand and supply curves may shift either to the right or to the left indicating an increase or decrease in demand and supply. Accordingly the rate of exchange would Also exchange. Figure 19.4 explains the above mentioned changes. Shifts in demand and supply curves have brought a change in the foreign exchange rate, that is, rupees offered per dollar. When supply of dollar increased, dollar became

cheap bringing down the exchange rate per dollar, that is from R to R0. The equilibrium exchange rate went up from R to R1 when the demand curve shifted to the right from D to D1 indicating an increase in demand for dollars. The shifts in demand and supply of foreign exchange(dollars) are the result of changes in underlying factors that affect demand and supply. At R0 rupee is stronger, that is, less rupees are offered per dollar. Whereas at R1 rupee has become weaker or depreciated, that is, more rupees are required to purchase one dollar. Factors Responsible For A Change in Equilibrium Exchange Rate Inflation: Relative inflation rates of the two countries influence the exchange rate. Between India and USA; let us say, the exchange rate is Rs 45 = 1 US $ in a given year. In the subsequent year if the rate of inflation is higher in India then USA, Indian goods and services will be costlier compared to USA, where inflation rate is lower. There will be less demand for Indian goods and services from USA, thus reducing the supply of dollars, whereas USAs rate of inflation being low, there will be more demand from India for USAs goods and services. The situation results in more demand for dollars and at the same time les supply. Increased demand with the given supply or decrease in supply of dollars, make the dollar costlier. Interest Rates: A higher rate of interest in India will attract foreign money to India to make advantage of interest differentials. Larger inflow of, say, dollar or euro would increase their supply and make them cheaper against the rupee. However, it should be noted that investors consider the differential in real interest rate, that is nominal rate of interest minus rate of inflation. Economic Growth: Higher economic growth rate attracts foreign capital to that country. China which enjoys higher economic growth attracts more foreign investment than others. India which enjoyed a better growth rate than many other countries has experienced its rupee appreciating in recent years, from Rs 48.395 in 2002-03 to Rs 44.411 in October 2010. At present (13 May, 2011) rupee-dollar exchange is Rs 44.79 = 1US $. Similarly countries with poor economic performance experience foreign capital moving out thus making the domestic currency weaker. Political and Other Factors : Political instability coupled with poor economic performance along with other factors like social unrest make people demand less of that countrys currency. Whereas those countries which enjoys a positive economic,

social and political environment find their currencies are more in demand. The above discussed factors influence the demand and supply of a particular countrys currency, thus rendering it strong or weak. Besides these factors, future expectation of the participants in foreign exchange market, leading to speculation would also bring in a change in exchange rate. Q12b. Explain the PPP theory and bring out its limitations? Ans. Purchasing power parity (PPP) theory which explains the determination of exchange rate is generally attributed to Gustav Cassel a Swadesh economist. However, its origin dates back to the writing of David Ricardo. During and after the first world war when many of the western countries allowed their exchange rates to float, it was observed that the changes in exchange rates were highly influenced by the changes in domestic prices. The essence of the theory is that under the competitive market structure and absence of transport cost and other restrictions on trade, identical goods which are sold in different markets will sell at the same price when expressed in common currency.

Purchasing power parity theory has two versions. One is based on a strict interpretation of the above mentioned law of single price and is termed Absolute Purchasing Power Parity. The other is liberal interpretation and called Relative purchasing power Parity.

ABSOLUTE VERSION OF PPP According to the absolute PPP, the identical basket of goods in two different countries must sell for the same price when expressed in the same currency. Stating differently, the exchange rate between the currencies of two different countries us decided by their respective purchasing power. For example if a basket of goods costs Rs. 100 in India and the same basket costs $ 2.5 U.S.A. then the exchange rate defined as Rupees per dollar will be Rs. 100 = $1. Algebraically, the absolute

Version of PPP can be stated as

Where R is the exchange rate defined as domestic currency units per unit foreign currency. P is the price of a basket of goods expressed in the domestic currency i.e. Indian rupees. P* is the price of identical basket of goods in the foreign country expressed in terms of foreign currency i.e. US $. According to absolute PPP a rise in home price level relative to the foreign price level will lead to a proportional depreciation against foreign currency. Here, if price for the basket of goods in India increases to 1250 while the price of the US basket remains the same, then the new rate of exchange will be Here the rupee depreciated while the USA dollar appreciates in terms of rupee Limitations of Absolute Version The absolute PPP has been criticized on the following grounds. 1. Neglects transport cost : The absolute version also neglects the cost of transporting commodities between two countries. In the absence of transport costs, it is true that prices of all commodities tend towards equality with each other and the market rate will move towards equilibrium rate. In fact the presence of transport costs makes the prices of internationally traded goods differ between countries. Thus the absolute form of the theory considers only the ideal conditions of absence of transport costs; which in practice does not exist.

2. Trade restrictions : Prices of traded good are distorted on account of a number of trade restrictions such as tariffs and other forms of protection. Domestic subsidies affect internal prices. Thus PPP does not reflect true purchasing power.

3. Assumes identical goods: The theory does not consider qualitative difference of goods. It is not possible to have all the goods included to work out the exchange

rate to be identical in quality in both the countries.

4. Non-economic factors are ignored: Prices of goods and services , are influenced by non-economic factors such as political atmosphere, social customs and other factors including value of system. Changes in these factors may bring a change in Domestic prices. Such changes may not have an immediate impact on the Exchange rate. Therefore at any given time market rate of exchange may not indicate the purchasing power parity between countries.

5. Non- traded goods: The absolute purchasing power parity theory postulates that prices of identical goods expressed in our currency are the same in different countries. The theory fails to consider the prices of non-traded goods. For traded goods, prices will be equalized through commodity arbitrage. Thus the law of one price, at best is applicable only to traded goods.

6. Neglects Capital Account: According to Domestic Salvator, the exchange established under the absolute version cannot be an exchange rate that equilibrates trade in goods and services as it neglects the inflow and outflow under capital account.

RELATIVE VERSION OF PPP

The absolute PPP states that exchange rate equals relative price levels. According P. R. Krugman and M. Obstfeld, the relative PPP states that the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage change in national price levels. Relative PPP thus translates absolute PPP from a statement of price and exchange rate levels into one about price and exchange rate changes. The relative version of PPP theory argues that the exchange rate will adjust by the amount of inflation differential between the two countries. Algebraically it can be stated as:

Where R1 = new equilibrium exchange rate R0 = Equilibrium rate in the base period P1 = Change in the price index in the home country (India) P2 = Change in the price index in other country (U.S.A.) For example, here the price index in India increases from 100 to 300 and in U.S.A. it goes up to 200. The base period rate is 40. Then the new exchange rate will be

Limitations of Relative Version

The relative version of PPP through considered as a superior approach, yet not without its drawbacks. The important of them are:

1. Difficult to select appropriate base year : The theory attempts to arrive at a new equilibrium rate on the basis of the old equilibrium rate. Economists have encountered many difficulties in calculating a correct base rate therefore it also becomes difficult to calculate the new rate.

2. Selecting relevant index numbers : Another difficulty encountered in calculating the new rate is in the use of index numbers. There are so many different types of price indices, the question would be - which one of them will be most relevant to the theory. e.g. - there is a wholesale price index, a general price index with weighted averages, a retail price index that the choice becomes difficult and unreliable.

3. Quality of goods ignored : The theory also ignores the differences in the quality of commodities sold in two countries. The difference in the quality of goods prevent the equalization of prices of goods and hence acts as an obstacle towards

working out an equilibrium rate of exchange.

4. Assumes on restrictions on trade : The theory disregards obstacles such as transport costs, tariffs, quotas, government interference which will prevent the actual market rate from conforming to the equilibrium rate of exchange.

5. Prices do not change at an uniform rate : The purchasing power parity theory considers that all prices and costs rise or fall uniformly. But in periods of hyper inflation same prices rise faster than others, e.g. food prices rise faster that the prices of manufactured goods. Because of the variations in the degree of price changes, the index numbers cannot be a true indicator of purchasing power.

6. No direct link between change in price and exchange rate : The theory assumes that changes in the price level get reflected in the rate of exchange. Such a direct and immediate link between price level and exchange rates may not exists. Many times prices may change but there may not be a change in the rate of exchange. Similarly exchange rate may change though internal price level remains stable.

7. Impact of a change in exchange rate on price level is neglected : The theory assumes that changes in price levels lead to changes in exchange rate, but changes in the exchange rate do not have any influence on the price level. Such a conclusion appears to be a hasty one as changes in exchange rates also influence prices. e.g. devaluation of currency makes imports costlier, thereby pushing up prices of commodities using imports in their manufacture.

8. Limited application to large countries : The theory has a greater relevance and applicability to small countries where a large part of the national income comes from international trade. In such countries prices levels and exchange \ rates are closely connected. But for larger countries the applicability of the theory is limited.

9. Capital transfers neglected : The theory takes into account only trade in merchandise. It excludes other items such as services, capital transfers and unilateral transfers all of which create a demand for and supply of foreign exchange. By excluding such factors the theory can only be termed as an incomplete theory. In fact it is more of a balance of trade theory rather than it balance of payments theory.

10. Too much emphasis on purchasing power : The theory places too much emphasis on purchasing power as a determining factor of rate of exchange. It ignores factors such as reciprocal demand of the trading countries which can influence the rate if exchange even with no change in price levels.

The purchasing power parity theory was expected to provide an answer to find out the exchange rate under floating exchange rate system, when changes in price in different countries are at variance. When countries come out from international economic and political disturbance, it is believed that PPP will provide the base on which an exchange rate can be determined. However, in the short-run, it was found that the exchange rate deviates from PPP. Nevertheless in the long-run the exchange rates are highly influenced by the purchasing power of respective currencies. Since 1990, the world band makes use of PPP to calculate the per capita income (adjusted To PPP) while working out the Human Development Index(HDI). It enables us to compare the real income level of different countries as against the exchange rate determined purely by market forces.

Q13a. Functions of foreign exchange market? 1. Transfer of purchasing power : International trade involves different currencies. Indians require purchasing power in the forms of U.S. dollars($) to purchase goods and services from that country. Similarly residents of other countries require Indian currency or any othe

acceptable currency for purchasing or investing in India. Foreign exchange market helps transfer purchasing power (currencies) between the people.

2. Provision of credit instruments and credit : For the purpose of transferring credit, credit instruments are used. These are in the form of telegraphic transfer, foreign exchange of 90 days can be discounted before the due date. Such a provisions enables to obtain credit from the commercial banks or authorized agents. 3. Coverage of risk : Exporters and importers may cover the possible risk due to a future change in the exchange rate through forward exchange market. The forward exchange market is where buyers and sellers agree to exchange currencies at some specified date in the future. Most of the developing countries have now opted for flexible exchange rate. Those developing countries which were under IMF followed the Bretton-woods system till 1971. Thereafter they too, like the advanced countries gave up the dollar exchange rate and allowed the market forces to determine the exchange rate. However to minimize the disadvantages of floating exchange rate, most of the developing countries have gone for a managed float or managed flexible exchange rate.Under the managed float the government intervenes to bring the required stability in the exchange rate.Exchange market intervention is defined as a sale or purchase of foreign currency by monetary authorities with the aim of changing the exchange rate of their own currency vis--vis one or more currencies. In the seventies, an overwhelming number of countries which switched to a flexible regime have followed a managed exchange rate system. In most of these countries central banks intervene in the foreign exchange markets to minimize the fluctuation in exchange rate. In case of the developing countries where the foreign exchange markets are thin and narrow, central banks leaning against wind intervention policy is to check erratic fluctuation in the exchange rate of its currency.The important reason put forward for government or Central Banks intervention to manage the exchange rate are :

1. Ability to produce a more appropriate rate : The government or monetary authorities may be in a better position to gather all the relevant information than the market. The market may have the wrong perception and may find it difficult to use the information to determine the appropriate rate of exchange. The authorities are in a better position than the

market in predicting the future course of policies and their implication for the exchange rate. For example, if there is an expected increase in money supply, the authorities would know the extent of it and accordingly plan the intervention to influence the exchange rate. In the absence of intervention, the market may indulge in speculation due to its inability to have accurate information.

2. To mitigate costs of overvalued or undervalued exchange rates: Exchange rates which derivate from the real exchange rates(in relation to purchasing power parity) lead to distortion in resources allocation between the domestic and external sectors. Undervaluation leads to inflationary pressure, while overvaluation brings in higher rates of unemployment. Changes in the exchange rate in either direction brings in uncertainty and affects investment decisions. The disturbances in economic activities caused by changes in the exchange rate can thus be kept under control if the authorities intervene and bring the necessary changes in the exchange rate.

3. To smoothen the economic adjustment process: A persistent surplus or deficit in the balance of payments leads to changes in the exchange rate to correct the disequilibrium. If the changes are larger, then the consequent disturbances in the domestic economic activities require adjustments in employment, price levels etc. If adjustments required are of higher magnitude, it becomes painful in its effects. Intervention can reduce such disturbances and the effects. An economy may be caught in a vicious circle of depreciation leading to price and wage rises which in turn leads to further depreciation i.e. depreciation-wage-price spiral. Intervention by the authorities may slow down or avoid the spiral. Intervention is also preferred by many economists to other methods of protection or correction like tariffs, exchange rate controls etc. Most of these methods have the tendency to become permanent and cause more damage to the economy by producing wrong exchange rate. Many developing countries have taken precautions to check the negative effects of flexible exchange rate by not allowing convertibility in the capital account. At the same time by adopting managed flexible exchange rate, they attempt to have the advantages associated with both flexible and fixed exchange rate system.

Q.13b. Write a note on RBI exchange rate management? The exchange rate policy at present is guided by the broad principles of careful monitoring and management with flexibility based on the underlying demand and supply conditions. Objectives of RBIs Intervention RBI intervenes in the exchange market to : (i) (ii) (iii) Determine the movements of exchange rate in an orderly manner over a period of time. Reduce excess volatility Prevent the emergence of destabilizing speculative activities. With the above objectives, the RBI tries to maintain adequate foreign exchange reserve to enable itself to conduct the intervention operation. Changes in Exchange Rate In the financial year 2008-09, the rupee depreciation to the extent of 12.5 percent against the US dollar. The annual average exchange rate of the rupee in 3008-09 was Rs. 45.99 per US dollar. In 2009-10 the rupee-dollar exchange rate increased from Rs. 45.648 to 47.417, that is, depreciation of the rupee by 4.766 percent during this period. Table 22.1 shows the exchange rate of the rupee and US dollar in selected years. Table 22.1 Year Rs per US dollar

1980-81 7.909 1990-91 17.943 1991-92 24.474. 1995-96 33.45 2000-01 45.684 2009-10 47.417 2010-11(December) 45.157 Source: Economic Survey, 2010-11, P.A78 and RBI The above table explains a continuous depreciation of the rupee since 1980-81.During the year 2010-11, the exchange rate appreciated (rupee) from Rs. 47.417 to Rs. 45.157.

India, at present, as stated earlier, has current account convertibility and also very liberal rules for the flow of foreign exchange under capital account, though we do not have capital account convertibility system. India attracts a good amount of foreign direct investment. The flow of foreign exchange on debt and non debt items is large enough to create wide fluctuations, that too frequently. To prevent the disadvantages of such fluctuations in exchange rate, the RBI intervenes in the foreign exchange market. Table 22.2 explains RBI intervention in foreign exchange market from 1995-96 to 2006-07. RBI intervened through purchase and sale of US $ from 1995-2010, to maintain stability by preventing wide fluctuation in the exchange rate, as shown in the following table 22.2 Table 22.2 Year 1995-96 1996-97 1997-98 1998-99 1999-00 1999-01 2001-02 Purchase/sale(Net) -0.3 7.8 3.9 1.8 3.3 2.4 7.0 Year 2002-03 2003-04 2004-05 2005-06 2006-07 2009-10 Purchase/sale(Net) 15.7 30.5 20.8 8.1 24.5 -2.50

The above table explains the purchase and sale of foreign currencies since 1995-96. The minus(-) sign indicates sale exceeding the purchase by that amount. In indicates RBIs attempt to keep the rate at a lower level, that is , to keep the price of foreign currency low in terms of the rupee. In other words not to allow the rupee to depreciate. The positive sign shows, purchase exceeding sale by that amount. Excess purchase Is resorted only to prevent appreciation of rupee which if happens, discourages exports. The ability to intervene, besides other things, depends on the size of foreign exchanges reserves. As and when India adopts full convertibility on capital accounts, RBI may

require a large amount of foreign exchange reserves, for its intervention operation. Under globalization exchange rate regime is most likely to become highly liberal even if it is not fully convertible. The responsibility of the central banks would accordingly increase. RBIs intervention as explain above, is termed unsterilized intervention. Such intervention explains the attempt to maintain a desired rate of foreign exchange rate. Foreign exchange transaction of the RBI, through purchase and sale of foreign currency leads to the increase or decrease in the supply of domestic currency. Accordingly it may increase or decrease the level of inflation. When the Central Bank (RBI) attempts to insulate or neutralize the effects of foreign exchange market intervention through use of monetary policy instruments it is called sterilized intervention. Purchase of foreign currency, in order to prevent the appreciation of domestic currency, results in an increase in the quality of domestic currency. This can be neutralized by the sale of government securities through open market operations, which reduces the money in circulation. RBI can also make use of Cash Reserve Ration (CRR) when an increase in CRR reduces the ability of commercial banks to create credit, thus reducing money supply. Similarly sale of foreign currency brings down the quantity of money in circulation. The foreign exchange market intervention by the RBI to maintain a desirable or appropriate rate of exchange is inevitable under our managed float exchange rate regime. By doing so it tries to achieve the objectives of its intervention as stated above. Q.14.Explain fixed and flexible exchange rate? Ans: Fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold. A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable, and is especially useful for small economies where external trade forms a large part of their GDP. It can also be used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. In addition, according to the MundellFleming model,

with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability. There are no major economic players that use a fixed exchange rate (except the countries using the euro and the Chinese yuan). The currencies of the countries that now use the euro are still existing (e.g. for old bonds). The rates of these currencies are fixed with respect to the euro and to each other. The most recent such country to discontinue their fixed exchange rate was the People's Republic of China, which did so in July 2005.[1] However, as of September 2010, the fixed-exchange rate of the Chinese yuan has already increased 1.5% in the last 3 months. Flexible rate: A flexible exchange-rate system is a currency system that allows the exchange rate to be determined by supply and demand.[1] After the failure of Bretton Woods system several currency regimes have emerged spanning the spectrum of rigidly fixed rate regime to independently flexible regimes.Every country that has its own currency must decide what type of exchange rate arrangement to maintain. In academic discussions, the decision is often posed as a choice between a fixed or a flexible exchange rate. In reality however, there are different varieties of fixed and flexible arrangements, providing a range of alternatives. The different alternatives have different implications for the extent to which national authorities participate in the foreign exchange markets. According to their degree of flexibility, exchange rate regimes are arranged into three categories: currency unions, dollarized regimes, currency boards and conventional fixed pegs are defined as fixed-rate regimes; Horizontal bands, crawling pegs and crawling bands are grouped into intermediate regimes; Managed and independent floats are defined as flexible regimes. Monetary union is a zone where a single monetary policy prevails and inside which a single currency or currencies, which are perfect substitutes, circulate freely. A monetary union has common monetary and fiscal policy to ensure control over the creation of high-powered money and the expansion of government debts; it has a central management of the common pool of foreign exchange reserves, external debts and exchange rate policies. The monetary union has common regional monetary authority i.e. common regional central bank, which is the sole issuer of economy wide currency, in the case of a full currency union. The monetary union reduces the time inconsistency problem by requiring multinational agreement on policy and reduces real exchange rate volatility. The potential drawbacks are that member countries suffering asymmetric shocks lose a stabilization tool. The cost depends on the extent of asymmetric costs and the availability and effectiveness of alternative adjustment tools. Dollarization/EuroizationA foreign currency acts as legal tender. Dollarization is a summary measure of the use of foreign currency in its capacity to produce all types of money services in the domestic economy. Monetary policy is delegated to the anchor country. Dollarization/Euroization reduces the time inconsistency problem and real exchange rate volatility. Under dollarization exchange rate movements cannot buffer external shocks. Currency board is monetary regime adopted by countries that intend to discipline their central banks, as well as solve their external credibility problems by tying their hands with institutionally binding arrangements. A currency board combines three elements: an exchange rate that is fixed to an anchor currency; automatic convertibility or the right to exchange domestic currency at this fixed rate whenever desired; and a long-term commitment to the system. The time inconsistency problem is reduced and real exchange rate volatility is diminished. A currency board system can be credible only if central bank holds official foreign

exchange reserves sufficient to at least cover the entire monetary base. Exchange rate movements cannot buffer external shocks. Fixed peg means fixed rate against a single currency or a currency basket. The time inconsistency problem is reduced through commitment to a verifiable target. Devaluation option provides potentially valuable policy tool in response to large shocks. Its potential drawbacks are: provides a target for speculative attacks, avoids real exchange rate volatility but not necessarily persistent misalignments, does not by itself place hard constrains on monetary and fiscal policy, the credibility effect depends on accompanying institutional measures and record of accomplishment. Crawling peg A rule based system for altering the par value, typically at a predetermined rate or as a function of inflation differentials. It is an attempt to combine flexibility and stability. Often used by (initially) high inflation countries pegging to low inflation countries in attempt to avoid trend real appreciation. At the margins a crawling peg provides a target for speculative attacks. Among variants of fixed exchange rates, it imposes the least restrictions, and may hence yield the smallest credibility benefits. The credibility effect depends on accompanying institutional measures and record of accomplishment. Bands exchange rate is flexible within a present band; endpoints are defended through intervention, typically with some intra-band intervention. An attempt to mix market-determined rates with exchange rate stabilizing intervention in a rule based system. It provides a limited role for exchange rate movements to counteract external shocks and partial expectations anchor, retains exchange rate uncertainty and thus motivates development of exchange rate risk management tools. On the margin a band is subject to speculative attacks. Does not by itself place hard constrains on monetary and fiscal policy, and thus provides only partial solution against the time inconsistency problem. The credibility effect depends on accompanying institutional measures, record of accomplishment and the characteristics of the band (firm or adjustable, secret or public, width, strength of intervention requirement). Managed float Exchange rates are determined in the foreign exchange market. Authorities can and do intervene, but are not bound by any intervention rule. Often accompanied by a separate nominal anchor, such as inflation target. The arrangement provides a way to mix marketdetermined rates with stabilizing intervention in a non-rule-based system. Its potential drawbacks are that it doesnt place hard constrains on monetary and fiscal policy. Absence of rule conditions credibility, gain on credibility of monetary authorities. Limited transparency. Pure float The exchange rate is determined in the market without public sector intervention. Adjustments to shocks can take place through exchange rate movements. Eliminates the requirement to hold large reserves. This arrangement does not provide an expectations anchor. Exchange rate regime places no restrictions on monetary and fiscal policy; time inconvenience arises unless addressed by other institutional measures.

Q.15a.Explain RBI intervention and rate played in RBI in stabilizing exchange rate? Ans: EXCHANGE MARKET INTERVENTION: Exchange Market Intervention' is defined as the sale or purchase of monetary authorities with the aim of changing the exchange rate of their own currency vis-a- vis on or more currencies. If there is too much demand for foreign currency, that currency will appreciate too much and depreciate the domestic currency. At this point, the central bank intervenes by releasing the foreign currency (from its reserves) in the market to stabilize the exchange rate. Similarly, if there is too less demand for foreign currency, that currency will depreciate and the domestic currency appreciates too much. At this point, the central bank intervenes by purchasing foreign currency from the market to stabilize exchange rate. i) APPROPRIATE EXCHANGE RATE: The central bank may be in a better position to gather all the relevant information than the other participants in the market. Hence it can appropriately predict the future course of policies and their implications on the exchange rate. So, it can plan its intervention in the market according to the situation and influence the exchange rate. In absence of intervention, the market may indulge in speculation due to lack of accurate information. ii) CONTROL OVER DISTORTIONS IN ECONOMIC ACTURTIES: Exchange rate which deviates from the real exchange rate (in relation to the purchasing power parity) may lead to distortion in resource allocation between external and domestic sectors. Undervaluation leads to inflationary pressure whereas overvaluation leads to higher rates of unemployment. Either undervaluation or overvaluation brings in uncertainty and affects investment decisions. This can be controlled by intervention of the monetary authorities by making necessary adjustments in the exchange rates.

iii) SMOOTHENS ECONOMIC ADJUSTMENT PROCESS: A persistent surplus or deficit in the balance of payments leads to changes in the exchange rate to correct the disequilibrium. These changes may result in disturbances in the domestic economic activities. Intervention can reduce such disturbances and their effects. iv) OTHERS ARGUMENTS: Managed flexibility facilitates economic growth due to proper flow of foreign trade. Higher economic growth increases employment and improves the standard of living of the people. Managed flexibility also facilitates higher investment due to growth potential which further boosts the economic growth of a nation. Q.15b. Write a note on: a) Speculation, b) Arbitrage, c) Hedging, d) Forward and Spot exchange rate? a) Speculation: Speculators are agents who speculate, that is, are purchase and sell foreign exchange with the intention of making a profit by taking the advantage of changes in exchange

rates. They participate in the forward exchange market by entering into forward exchange deal. They do so on the basis of their own calculation of the difference between the forward rate and the spot rate that may prevail on a future date. For example if a speculator enters to sell a dollar at Rs 45.00 after three months with expectation of the dollar becoming cheap and the spot rate after three months is Rs 44 = 1$, the speculators purchase the dollar for spot rate (Rs 44) and sell for the agreed forward rate (Rs 45), thus making a profit of Rs 1 per dollar. He may incur loss if the spot rate crosses Rs 45. Speculators, however, try to minimize their loss by entering into spot and forward arrangements simultaneously (swaps). For example, let us say, the US $ is quoted as follows: Spot Rs 45 = $ 1 6 months forward 45.50 = 1 $ If the speculators anticipates that the US $ may go up to Rs 46.00, he will take a long Position1 and buy US $ at Rs 45.50, six months forward. If his calculation turn out to be true, he will sell his US dollars at Rs 46.0 and earn profit of Rs 0.50 per dollar. Suppose the speculator anticipates a decrease in the value of the US $ to Rs 44,50, then he will take a short position2 in dollar by selling them 6 months forward. If expectations turn out to be true, he will make a profit R 1.00 per dollar (purchasing on the spot and selling at the agreed forward rate of Rs 45.50.) If, the rates go up to 46, then he will incur a loss Rs 0.50 per dollar. The forward exchange rate is determined by the interaction of hedgers, arbitrageurs and speculators. Speculators are in the market for the purpose of earning profit, their activities may lead to destabilization of foreign exchange market. In a fixed exchange rate system, the scope for speculation is limited yet one could speculate on governments move on possible devaluation and enter into forward contracts. Depending on the size of foreign exchange deal entered on the speculation move the market may feel the impact. Speculation may have stabilizing or destabilizing effect. Stabilizing speculation refers to the purchase of a foreign currency when the domestic price of a foreign currency falls with expectation of its increase and of earning profit. It also refers to the

sale of foreign exchange when its price increases with the expectation that it would soon fall. b) Arbitrage: Arbitrageurs are agents (usually banks) who intend to make a riskless profit out of discrepancies between interest rate differentials and forward discount and forward premium. Arbitrageurs enter into arbitrage, that is, to purchase of an asset in a low price market and its riskless sale in a higher price market. This process leads to equalization of prices of an asset in all the segments of the market. Difference in prices if at all, is not more than transport or transaction cost. Arbitrageurs will take advantage of the different exchange rates prevailing in various foreign exchange markets due to interest rate differentials. Let us explain this with an example suppose Rs = $ exchange rate prevailing in India earning a profit of Rs 40 = 1$. People will purchase dollars in USA and sell it in India earning a profit of Rs 2 per dollar. In the process, increasing demand for dollars in USA will push up the prices to Rs 41 and more supply of dollar will bring down the price of dollar in India to Rs 41. Arbitrage, therefore helps equalize the exchange rate in different markets. Arbitrage is possible within the country or within the local market where two banks offer two different bids and asking rates. Let us illustrate this with an example. Following are the quotes of bank A and bank B. A B INR/$ 48.50/48.60 48.40/48.45 The rates are close to each other. Yet a firm or even a dealer may take the advantage of the situation. A dealer can purchase $ 1,00,000 from bank B, and sell it to bank A as 48.50, thus making 0.5 paise profit on a dollar, earning a sum of Rs 5,000=00. The Profit earned is without may risk and blocking capital.

Due to the development of communication system the dealers will exploit the situation to their advantage. The difference in rate, however, will soon disappear due to the operation of market forces. Heavy demand experienced by bank B will push its selling (asking) price and increased supply of dollar coming to bank A will bring down its buying (bidding) price. The arbitrage opportunity thus will disappear very fast.

If the arbitrage margin is very small, the firms or dealers will not get into arbitrage operation as the execution of the transaction is not very simple and the trouble and cost involved is not worth the small amount of profit. When only two currencies and two countries are involved in arbitrage it is called two-point arbitrage. When three currencies and three monetary authorities are involved, we have triangular or three point arbitrage. Triangular arbitrage operates in similar way to that of two point arbitrage. It increases the demand for cheaper currency and increases supply of dearer currencies. Thus elimination differences in exchange rates in different centers and in turns unifying all the monetary centers into a single foreign exchange market. Interest rates and arbitrage: There is a relationship between interest rate and rate of inflation. According to Irvin Fisher, a countrys nominal interest rate (i) is the sum of required real rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I). This can be stated as i = r+I If the real rate of interest in a country is 5 percent and annual inflation is 7 percent, the nominal interest rate will b e 12 percent. This relationship is called Fisher Effect, according to which, a strong relationship seems to exist between inflation rates and interest rates. If the real interest rates between the countries differ then arbitrage takes place. For example if the real interest rate in India is 6 percent and in USA 4 percent then money will flow to India to take the advantage of the difference in real interest rate. The process will lead to an increase in money supply in India leading to a lower real interest rate and shortage of dollars in USA and consequently an increase in real interest rate. According to the purchasing power parity (PPP) theory there is a link between inflation and exchange rate as the interest rates reflects expectations about inflation, it follows that there must also be a link between interest rate and exchange rate. Such a link is known as International Fisher Effect. It states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries. If Indias nominal rate of interest is higher than USAs with the expectation of higher rate of inflation, the value of Rupee against dollar should fall by that interest rate differential in future.

Interest arbitrage may be uncovered or covered. Uncovered Arbitrage: In this system, arbitrageurs would take a risk to earn profit by investing in a high interest bearing risk free securities in a foreign market. His earnings would be according to his calculations if the currency of the foreign market where he invested done not depreciate. If the depreciation is equal to the difference in interest rate, the investor would not incur loss. However, if the depreciation is more than interest rate differential , then the arbitrageur will incur loss. Covered Arbitrage: International investors would like to avoid the foreign exchange risk, thus, interest arbitrage is usually covered. For this purpose the investors purchase foreign currency to invest the same in a foreign country which has higher rate of interest. At the same time the investor sell forward the amount of the foreign currency he is investing plus the interest on the invested amount for a period which will coincide with the maturity of the investment. The covered interest arbitrage refers to the spot purchase of the foreign currency to make the investment and offsetting simultaneous forward sale (swap) of the foreign currency to cover the foreign exchange risk. Under this system when the foreign investment matures (usually 3 months) the investor will get the domestic currency equivalent of the amount invested, plus interest earned. However, the currency with higher rate of interest is usually at a forward discount, the net return on the investment is roughly equal to the interest differential (higher interest) minus the forward discount on foreign currency. The less earnings due to forward discount can be considered as the cost of insurance against foreign exchange c) Hedging: Hedgers are agents who enter the forward exchange market to protect themselves against the risk arising out of exchange rate fluctuations. Hedging undertaken by hedgers refers to an operation to protect themselves against the risk arising out of exchange rate changes. To understand the risk, let us assume an Indian importer who imports goods from U.S.A. worth $50,000, has to make the payments in three months time. The spot rate at the moment is Rs 45 = 51 which requires Rs. 22,50,000. Due to uncertainty of the market, if the importer fears a depreciation of Rupee, he will have to pay more than Rs. 45/- = 51 three months hence. Therefore he may enter into buying dollar forward today, through an agreement with commercial banks or authorized agents. If he enters into an agreement to purchase at the rate of Rs 45.25, he does so as he

fears the depreciation of rupee. After three months he requires to pay an additional Rs 12.500 more. If the spot rate is more than Rs. 45.25 after 3 months then the hedgers stand to gain. If it turns out to be only Rs 45.00 or less than that, hedgers are the losers. The advantage of forward market which provides this facility makes the importers sure of the money that he has to pay for obtaining $ 50,000. Basically, the strategy of hedging involves increasing hard currency which is likely to appreciate and decreasing soft currency which is likely to depreciate and at the same time decreasing hard currency liabilities and increasing soft currency liabilities. For example, if depreciation of Indian rupee is expected, the basic hedging strategy would be: reduce the level of cash rupee, decrease accounts receivable, increase local currency borrowing, delay accounts payable and sell weak currency forward, speed up remittance of dividend to the parent company, speed up all the payments to be done in hard currency and delay all the receivable from abroad. In case, the local currency is expected to appreciate, then the hedging strategy would be to increase the stock of local currency, speed up the collection, buy local currency forward, reduce imports of soft currency goods, reduce local currency borrowing, delay remittance. Hedging helps the firms cover the risk arising out of changes in exchange rates. It is specially essential for those firms which have large amounts receivable or commitments to pay in foreign currencies. d) Spot and forward exchange rate: In foreign exchange market two types of exchange rate operations take place. They are spot exchange rate and forward exchange rate. Spot exchange rate Spot exchange rate is the current exchange rate between the two currencies. It is determined by the market forces i.e. demand for and supply of foreign exchange. It is the rate at which immediate delivery of foreign exchange has to be made. In reality, specially for large transactions, there is a two day time lag between the spot purchase or sale and the delivery. The time lag is allowed for paperwork, verification and clearing of payments. The basic principle of the spot exchange rate is that it can be analyzed like any other price with the help of demand and supply forces. The exchange rate of the dollar is determined by the intersection of demand for and supply of dollars in the foreign

exchange. The demand for dollar is derived from the countrys demand for imports which are paid in dollars and the supply is derived from the countrys exports which are sold in dollars. The exchange rate is determined by the market forces would change as these forces change in the market. The primary price makers buy (bid) or sell (ask) the currencies in the market and the rate continuously change in a free market depending on demand and supply. The primary dealers quote two-pay prices and are ready to deal on either side, that is, to buy and sell. A bank quote its rate in the following manner: INR/USD 48.50bid/48.75 ask The above quote expresses the units of rupee (INR) the dealer is ready to pay (48.50) While buying the dollar that is his bid(buying) price for one US dollar (USD). Rupees 48.75 is the ask (selling) price at which he is willing to sell one dollar for those who want to purchase the dollar. In the transaction there is spread between bid and ask price enabling the dealer earn a profit of Rs 0.25 on a transaction of one dollar. Spot rate and spot date Spot rate refers to the currency exchange rate which may change many times during the day. Spot date, on the other hand refers to the delivery date of the currency. It is the settlement date when the actual exchange of currencies rake place. As per the international practices, delivery of currency of the spot transaction takes place pm the second working day after the day of settlement. Accordingly for a spot deal struck on Wednesday, delivery will take place on Friday, subject to the condition that both Thursday and Friday are working days. Size and Nature Spot exchange rates are determined in a gigantic global interbank foreign exchange market. The market operates at a lightning speed and in a vast amount of money. The money moves between the banks quickly and in a large amounts making the interbank foreign exchange market the largest financial market. Most of the transactions among banks in the international foreign exchange market are spot transactions which account for more than two-thirds of all business transacted in the foreign exchange market. In theory, a spot transaction is one in which the exchange of currencies rake place immediately, but in reality spot transactions are settled on the second working day. The spot dealing between an individual like a tourist and banks / money changer is settled by exchanging the currencies on the spot.

The spot exchange rate is determined by the demand and supply of foreign exchange through primary dealers. Currencies of different countries are designated by ISO code. Following are the codes of some of the selected currencies. Forward exchange rate When forward exchange rate is determined in the foreign exchange market the purchase and sale of foreign exchange is done currently for delivery and payment at a fixed date in the future. These contracts usually have maturities of 30, 60 or 90 days. There are transactions for 180 and 360 days also. The quotation for forward exchange rate can be in two different ways. It can be expressed in terms of the amount of local currency at which a dealer will buy and sell a unit of foreign currency. This is termed as the outright rate. The forward rate can also be quoted in terms of points, called the forward points. These points are added to the spot rate if the foreign currency is traded at a premium. The forward points are subtracted from the price, if the trading is expected to be at a discount. The rate decided in this manner is called the outright forward rate which is the forward rate adjusted for forward points. To explain will an example, let us say that the spot exchange rate of RS and $ is INR/USD 44.50bid/40.75 ask forward exchange rate after 180 days can be quoted through points Spot rate Forward rate(points) Six months swap 44.50bid/44.70 ask 20-25 Since the points are in ascending order, the points to be added, which means

exchange rate is at a premium.he forward rate after 180 days will be 44.70bid/44.95ask If the forward rate is going to be at discount then the points will stated in descending order, that is Spot rate Forward rate(points) Six months swap 44.50bid/44.70 ask 25-20 Hence the forward rate will be calculated by subtracting the points, hence the forward rate will be 44.25bid/44.50 ask The basic question required to be answered I, why anyone should wish to agree into a contract to buy or sell foreign exchange at some future time, and how the spot and

forward markets are linked? The link between the spot and forward exchange rate comes from the actions of three groups of economic agents who use the markets: arbitrageurs, hedgers and speculators. Interaction between these three groups determine the forward exchange rate. One of the conditions that must hold in the forward exchange market is that, for every forward purchase there must be a forward sale of the currency. Forward rates frequently differ from prevailing spot rate. If a currency is worth less in the future than the present, then the forward rate will be at a discount and an opposite situation will have a premium on the forward exchange rate. Need for forward market is felt to cover future uncertainty and also possible loss due to fluctuations on the exchange rate. The exporters and importers usually enter into forward transaction to avoid possible loss. In the floating or flexible exchange rate system the possibility of wide fluctuation in exchange is more. Therefore both exporters and importers safeguard their position through a forward arrangements. By entering into such an arrangement both parties minimize their loss. In the forward market, a swap arrangement also rakes place to cover the risk involved in the forward deal. Usually the banks which enter with a forward arrangement with customers to sell US dollars at a certain rate would cover themselves against risk by entering with another bank to purchase US dollars at fixed rate. Such swaps help the bank to match the outflow and inflow of dollars and also earn profit based on swap margin. Factors influencing forward exchange rate include the position of balance of payments of the country, interest rates prevailing in the countries of currencies economic factors, political environment, degree of speculation, intervention by the monetary authority etc. A strong balance of payment position, higher rate of interest at home, favorable economic and political factors at home, expectation of higher rate(in domestic currency) in the future by speculators, intervention by the central bank to support it currency and other favorable factors will result in a premium rate of the domestic currency vis--vis foreign currencies. In a fully floating exchange rate system the forward exchange rate exchange rate premium or discount is left to the speculation of dealers about the changes in factors affecting the forward rate. In a managed float, the role of the central bank is important besides the other factors. Under the fixed exchange rate the margin will be very small except in times of a possible devaluation which is open for speculation.