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NATIONAL INCOME

Methods Of Calculating National Income

All the three methods of measurement of National Income provide identical results, illustrated below in the table.

The above able shows that either of the three methods lead us to the same result, that is the value of the GDP remains the same. DIFFICULTIES INCOME IN THE MEASUREMENT OF NATIONAL

The correct estimation of national income is by no means an easy task. Difficulties of various kinds are generally faced in the

measurement of national income. These difficulties may be Classified into two categories : (i) Conceptual difficulties or Theoretical difficulties, and (ii) Practical difficulties. While the theoretical difficulties a ear in almost all countries the practical difficulties are generally' witnessed in the underdeveloped countries. Conceptual difficulties. These difficulties relate to the various concepts of national income. Some of the important conceptual difficulties are as follows: (i) Determination of intermediate and final goods. The national income of a country consists of only final goods and services. Final goods refer to those goods which are readily available for consumption. Final goods are required for their own sake. While estimating the national income, it is always not possible to make a clear distinction between intermediate goods and final goods.For example, cotton used at a surgical Clinic is the final product for a doctor, but if the same cotton is used by the cotton milt to manufacture cloth, it will be treated as intermediate product. To stretch this example further, if this cloth manufactured by Delhi Cloth Mills is used by Wings or Liberty company to manufacture ready-made garments, this cloth will be regarded as an intermediate product. Services without remuneration. In our daily life we observe a father teaching his son, a mother taking care of her child, a housewife looking after the household affairs, and so on. No factor payment is made for these services, and therefore, they do not form part of the national income. But if the same services are provided by a tutor, a baby-keeper and a house-maid, respectively, factor payments shall have to be made. So, in the changed circumstance the same services will be included in the national income.

(ii)

(iii)

Transfer payments. Transfer payments refer to those payments for which e receive has not to perform any economic' activity. Pocket allowance given to a son, by his father, or the pension paid by the government to the retired employees, are a few examples of transfer payments Transfer payments are the sources of income for the households and the business firms, but these do not form part of the national income. Pricing of products. Valuation of the final products for the purposes of national income estimation is a difficult task. We know that the prices change every month, every week, and in certain cases from day to day; therefore, which price should be chosen to ascertain the money value of the products, is really a tough choice. Besides, we find different typed of prices existing in the market, e.g., wholesale price, retail price, ,etc.

(iv)

Practical difficulties. Different types of practical difficulties arise in the estimation of national, income. More important difficulties are as follows: (i) Non-monetised sector. A large part of the underdeveloped countries consists of non- monetised sector, Nan-monetised sector refers to that part of the economy where the exchange transactions are not performed in money or in order words, barter system of exchange prevails in the non-monellsed sector. Goods which do not enter into the monetary sector are thus excluded from the national income. Lack of occupational specialisation. It means that a person performs a number of economic activities at one and the same time. Consequently, an individual has different sources of earnings at one and the same time. Far example, a teacher teaches in the school and also takes private tuitions in extra time, or a farm-laborer works on the farm and also works in a factory in the off season, and so on. It becomes impossible to trace out, the main source of earning of an individual in such cases. In the absence of adequate,

(ii)

information about the source of income, a large part of income remains excluded from the national income. (iii) Non-availability of reliable data. This difficulty arises mainly in the underdeveloped countries where majority of people are living in the world of dark letters. Illiterate people neither understand the importance of the income-data, nor can they maintain proper records in this respect. Sometimes, the producers, in order to evade income tax, deliberately distort information relating to their incomes. Sometimes, the enumerators do not possess requisite knowledge of collecting, classifying and analysing the data. Enumerators and investigators vitiate investigations by suing their personal bias and prejudices. National income estimation based upon inadequate and inaccurate statistics need not be dependable. Goods for self-consumption. Producers of final goods retain a part of their produce for self- consumption. Far example, a farmer retains a part of the total crap far personal consumption, or a weaver retains a part of the produced cloth far self-consumption, and the like. Goods which, are retained by the producer for personal consumption do not fetch, money price, and are therefore excluded from the national income. Double counting. Many goods and services appear mare than once in the national income estimation. It is not always possible to make a clear distinction between intermediate goods and final goads. Likewise, whether the durable goods like building, furniture, machines, etc., should form part of a year's national income or should be continuously included in the national income till these are finally consumed. We 'can further take the example of goods and services which satisfy communal wants The government constructs roads, parks, hospitals, bridges, etc., far the welfare of the masses, but different people derive different utilities from these services. How to make allowance for such services in the national income is again a difficult problem.

(iv)

(v)

Definition: Business Cycle A business cycle is a swing in the Total National Output, Income and Employment, generally lasting for a period of 2-10 years, characterized by wide spread expansion or contraction in most sectors of the economy. Business Cycle is divided into 2 phases, namely, Recession and Expansion. Peaks and through highlights the turning points of the cycle. The pattern of business cycle is irregular. No two business cycles are similar. The timing or duration of a business cycle cannot be accurately predicted. Characteristics of Business Cycle: 1. Consumer demand for durables rises sharply. Business inventories of durable goods are low because supplies do not rise as rapidly as the rise in demand. Business reacts by increasing production and real GDP rises. Business investment in plant also rises rapidly. 2. The demand for labour rises resulting in higher wage rate and high levels of employments. 3. As output rises, inflation rate goes up. As a result, demand for raw material also rises with price. 4. Business profits rise sharply during upturns. In anticipation of high business profits, a stock price also rises. The rise in stock prices is further fuelled by rising investor demand for stock. 5. Interest a rate generally raises on account of a sustained is in demand for credit. Recession is the opposite of an expansionary business cycle phase and us such, all the characteristic features of a recession are just the opposite of an expansion. Phases of Business Cycle A business cycle is not a regular, predictable, or repeating phenomenon like the swing of the pendulum of a clock. Its timing is random and, to a large degress, unpredictable. There are 2 phases in business cycle namely, expansion or prosperity and recession or the downturn. However, these phases do not emerge all of a sudden. There is a gradual building up and slippage into these phases. A business cycle is identified as a sequence of four phases:

1. Contraction (A slowdown in the pace of economic activity) 2. Trough (The lower turning point of a business cycle, where a contraction turns into an expansion) 3. Expansion (A speedup in the pace of economic activity) 4. Peak (The upper turning of a business cycle) A business cycle is comprised of distinct phases, a general period of expansion followed by a general period of contraction. The transition from contraction to expansion is a trough and the transition from expansion to contraction is a peak. The given figure graphically represents the phases of a business cycle. The cyclical line shows the various phases of the business cycles which moves above and below.

1. Contraction One of the two primary business-cycle phases is a contraction. A contraction is a period of declining economic activity. The steep slope between the Peak point and the Trough point of the economy is the contraction. Clearly the economy declines over this segment. A contraction generally takes the economy from at or above the long-run trend to below the long-run trend. A contraction typically lasts about a year, but could be as short as six months or as long as eighteen months. The longest contraction on record, occurring during the Great Depression, lasted almost four years. 2. Trough A contraction does not last forever, at least none have so far. The end of a contraction, and the onset of an expansion is a trough. It is the end of the previous contraction that took the economy from point A to point B. While a trough, the lowest level of the business cycle, might not seem like a good thing, it really is. A trough means that the contraction has ended and that an expansion is about to begin. 3. Expansion The second of the two primary business-cycle phases is an expansion. An expansion, which is a period of increasing economic activity. The steep rise between the Trough point and the Prosperity point of the economy is the expansion. Clearly the economy increases over this segment. An expansion generally takes the economy from below the longrun trend to at or above the long-run trend. The early part of an expansion is usually termed a recovery because the economy is "recovering" from the contraction. An expansion typically lasts about three to four years, but could be as short as one year or as long as a decade. The longest expansion on record, occurring during the 1990s, lasted ten years. 4. Peak An expansion, like a contraction, eventually comes to an end. The end of an expansion, and the onset of a contraction is a peak. It is the end of the previous expansion that took the economy from point 1 to point 2.

While a peak, the highest level of the business cycle, might seem like a good thing, it really has a down side. A peak means that the expansion has ended and that a contraction is about to begin.

WORLD TRADE ORGANISATION

History of The World Trade Organization 1. International organization embodied in the results of the Uruguay Round 2. Established: 1 January 1995 3. Membership --> around 130 countries 4. The Secretariat: around 500 staff, headed by a Director-General, based in Geneva 5. Cornerstone of the multilateral trading system Trade in goods Trade in services Protection of intellectual property rights 6. The WTO contract Rights and obligations Dispute settlement 7. Successor to GATT

Difference between WTO and GATT Nature The GATT was a set of rules, with no institutional foundation, applied on a provisional basis. The WTO is a permanent institution with a permanent framework and its own secretariat.

Scope The GATT rules applied to trade in goods. The WTO Agreement covers trade in goods, trade in services and trade-related aspects of intellectual property rights. Approach Whilst the GATT was a multilateral instrument, a series of new agreements were adopted during the Tokyo Round on a plurilateral - that is, selective basis, causing a fragmentation of the multilateral trading system. The WTO has been adopted, and accepted by its Members, as a single undertaking: the agreements which constitute the WTO are all multilateral, and therefore involve commitments for the entire membership of the organization. Dispute settlement The WTO dispute settlement system has specific time limits and is therefore faster than the GATT system; it operates more automatically, thus ensuring less blockages than in the old GATT; and it has a permanent appellate body to review findings by dispute settlement panels. There are also more detailed rules on the process of the implementation of findings.

Structure of WTO All WTO members may participate in all councils, committees, etc., except Appellate Body, Dispute Settlement panels, and plurilateral committees. Highest level: Ministerial Conference The topmost decision-making body of the WTO is the Ministerial Conference, which has to meet at least every two years. It brings together all members of the WTO, all of which are countries or customs unions. The Ministerial Conference can make decisions on all matters under any of the multilateral trade agreements. Second level: General Council The daily work of the ministerial conference is handled by three groups The General Council, The Dispute Settlement Body and The Trade Policy Review Body.

1. The General Council- It sis the WTOs highest-level decisionmaking body in Geneva, meeting regularly to carry out the functions of the WTO. It has representatives (usually ambassadors or equivalent) from all member governments and has the authority to act on behalf of the ministerial conference which only meets about every two years. The council acts on behalf on the Ministerial Council on all of the WTO affairs. The current chairman is Amina Chawahir Mohamed (Kenya). 2. The Dispute Settlement Body - Made up of all member governments, usually represented by ambassadors or equivalent. The current chairperson is H.E. Mr. Muhamad Noor YACOB (Malaysia). 3. The Trade Policy Review Body (TPRB) - the WTO General Council meets as the Trade Policy Review Body to undertake trade policy reviews of Members under the TRPM. The TPRB is thus open to all WTO Members. The current chairperson is Don Stephenson (Canada). Third level: Councils for Trade The Councils for Trade work under the General Council. There are three councils - Council for Trade in Goods, Council for Trade-Related Aspects of Intellectual Property Rights, and Council for Trade in Services - each council works in different fields. Apart from these three councils, six other bodies report to the General Council reporting on issues such as trade and development, the environment, regional trading arrangements and administrative issues. 1. Council for Trade in Goods- The workings of the General Agreement on Tariffs and Trade (GATT) which covers international trade in goods, are the responsibility of the Council for Trade in Goods. It is made up of representatives from all WTO member countries. The current chairperson is Vesa Tapani Himanen (Finland). 2. Council for Trade-Related Aspects of Intellectual Property Rights- Information on intellectual property in the WTO, news and official records of the activities of the TRIPS Council, and details of the WTOs work with other international organizations in the field.

3. Council for Trade in Services- The Council for Trade in Services operates under the guidance of the General Council and is responsible for overseeing the functioning of the General Agreement on Trade in Services (GATS). Its open to all WTO members, and can create subsidiary bodies as required. The current chairperson is Claudia Uribe (Colombia). Fourth level: Subsidiary Bodies There are subsidiary bodies under each of the three councils. 1. The Goods Council- subsidiary under the Council for Trade in Goods. It has 11 committees consisting of all member countries, dealing with specific subjects such as agriculture, market access, subsidies, anti-dumping measures and so on. Committees include the following: Information Technology Agreement (ITA) Committee State Trading Enterprises Textiles Monitoring Body - Consists of a chairman and 10 members acting under it. Groups dealing with notifications - process by which governments inform the WTO about new policies and measures in their countries. 2. The Services Council- subsidiary under the Council for Trade in Services which deals with financial services, domestic regulations and other specific commitments. 3. Dispute Settlement panels and Appellate Body- subsidiary under the Dispute Settlement Body to resolve disputes and the Appellate Body to deal with

appeals.

INDIAS FOREIGN TRADE UNDER WTO: OUTLOOK FOR 21ST CENTURY. The period from 1991 to 2003 has also been marked by rapid growth of Indias exports exceeding 11 percent per annum as against 8 percent growth in world exports during the same period. However, the share of Indias exports in world trade has declined since independence from 2.2 percent in

1948 to 1.0 percent in 1993 and was pegged at 0.7 percent in 2001. Previously, various kinds of rigid restrictions were imposed not only on imports but also on the entire range of transactions involving foreign exchange. Within the domestic market, the large scale private sector was subjected to highly restrictive system of licensing and a variety of other discretionary controls which involved case by case disposal. Now India has submitted its comprehensive proposals with a view to safeguarding the food and livelihood security of large subsistence level farming community and maximizing export opportunities for Indian agricultural products by seeking a reduction in high tariffs and subsidies prevalent in developed countries. India has forwarded its request in respect of medical, dental and health services, audio-visual services, tourism services, architectural services, computer aided services and maritime services. Other services of interest to India and on which request are being formulated, include computers and related services, accountancy, auditing and book keeping services, urban planning and landscape services and construction of audio-visual services. REFORMS PROCESS AND THE INDIAN EXPORTS World exports are likely to cross 25000 billion dollars by 2020. Indias exports should therefore exceed 500 million dollars to accomplish this vision. There is great export potential for our agricultural sector. Our IT exports alone cross 150 billion dollar mark by year 2020. What is required is to formulate a high focused strategy and its rigorous implementation o achieve the desired export thrust. The vision of export growth requires that the average rate of inflation over the next two decades is kept below 4 percent per annum which would help in restricting the average rate f currency depreciation to round 2 percent per annum and also maintaining a relatively stable interest rate regime. Fulfillment of our export vision will raise Indias export GDP ratio to round 20 percent over the next two decades. The vision of the 21st century sounds very ambitious but it is attainable if we can put our act together and pursue the goal relentlessly through well coordinated hard work, total commitment and complete dedication.

Trade-Related Aspects of Intellectual Property Rights (TRIPS) The Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPs) is an international treaty administered by the World Trade Organization (WTO) which sets down minimum standards for most forms of intellectual property (IP) regulation within all member countries of the World Trade Organization. It was negotiated at the end of the Uruguay Round of the General Agreement on Tariffs and Trade (GATT) treaty in 1994. Specifically, TRIPs deals with copyright and related rights, such as rights of performers, producers of sound recordings and broadcasting organisations; geographical indications, including appellations of origin; industrial designs; integrated circuit layout-designs; patents, including the protection of new varieties of plants; trademarks; trade dress; and undisclosed or confidential information, including trade secrets and test data. TRIPs also specifies enforcement procedures, remedies, and dispute resolution procedures. The obligations under TRIPs apply equally to all member states, however developing countries are allowed a longer period in which to implement the applicable changes to their national laws. Although subsequent developments have expanded the original requirements of TRIPs, the agreement itself introduced intellectual property law into the international trading system for the first time, and remains the most comprehensive international agreement on intellectual property to date. TRIPS has been criticised by the alter-globalization movement, concerning for example its consequences for the AIDS pandemic in Africa.

Trade-Related Investment Measures (TRIMS) In the late 1980's, there was a significant increase in foreign direct investment throughout the world. However, some of the countries receiving foreign investment imposed numerous restrictions on that investment designed to protect and foster domestic industries, and to prevent the outflow of foreign exchange reserves. Examples of these restrictions include local content requirements (which require that locally-produced goods be purchased or used), manufacturing requirements (which require the domestic manufacturing of certain

components), trade balancing requirements, domestic sales requirements, technology transfer requirements, export performance requirements (which require the export of a specified percentage of production volume), local equity restrictions, foreign exchange restrictions, remittance restrictions, licensing requirements, and employment restrictions. These measures can also be used in connection with fiscal incentives as opposed to requirement. Some of these investment measures distort trade in violation of GATT Article III and XI, and are therefore prohibited. Until the completion of the Uruguay Round negotiations, which produced a well-rounded Agreement on Trade-Related Investment Measures (hereinafter the "TRIMs Agreement"), the few international agreements providing disciplines for measures restricting foreign investment provided only limited guidance in terms of content and country coverage. The OECD Code on Liberalization of Capital Movements, for example, requires members to liberalize restrictions on direct investment in a broad range of areas. The OECD Code's efficacy, however, is limited by the numerous reservations made by each of the members. In addition, there are other international treaties, bilateral and multilateral, under which signatories extend most-favoured-nation treatment to direct investment. Only a few such treaties, however, provide national treatment for direct investment. Moreover, although the APEC Investment Principles adopted in November 1994 provide rules for investment as a whole, including non-discrimination and national treatment, they have no binding force. Legal Framework GATT 1947 prohibited investment measures that violated the principles of national treatment and the general elimination of quantitative restrictions, but the extent of the prohibitions was never clear. The TRIMs Agreement, however, contains statements prohibiting any TRIMs that are inconsistent with the provisions of Articles III or XI of GATT 1994. In addition, it provides an illustrative list that explicitly prohibits local content requirements, trade balancing requirements, foreign exchange restrictions and export restrictions (domestic sales requirements) that would violate Article III:4 or XI:1 of GATT 1994. TRIMs prohibited by the Agreement include those which are mandatory or enforceable under domestic law or

administrative rulings, or those with which compliance is necessary to obtain an advantage (such as subsidies or tax breaks). Future Challenges The TRIMs Agreement is only a first step toward eliminating trade distortions. Although some policies, such as certain export requirements, are not expressly prohibited by the TRIMs Agreement, it is important that governments understand the capacity of such measures to distort trade. The TRIMs Agreement is scheduled to come up for review within five years of the entry into force of the WTO Agreement and efforts should be made to incorporate appropriate new rules to address such additional policies at that time. GLOBALISATION Introduction & Meaning The term "globalization" has acquired considerable emotive force. Some view it as a process that is beneficial a key to future world economic development and also inevitable and irreversible. Others regard it with hostility, even fear, believing that it increases inequality within and between nations, threatens employment and living standards and thwarts social progress. Globalisation is a primarily economic phenomenon involving the increasing interaction or integration of national economic system through the growth in international trade, investment and capital flows. However, one can also point to a rapid increase in cross border, social, cultural and technological exchanges as a part of globalization. By contrast, in the 1970s and 1980s when many countries in Latin America and Africa pursued inward-oriented policies, their economies stagnated or declined, poverty increased and high inflation became the norm. In many cases, especially Africa, adverse external developments made the problems worse. As these regions changed their policies, their incomes have begun to rise. An important transformation is underway. Encouraging this trend, not reversing it, is the best course for promoting growth, development and poverty reduction.

The crises in the emerging markets in the 1990s have made it quite evident that the opportunities of globalization do not come without risksrisks arising from volatile capital movements and the risks of social, economic, and environmental degradation created by poverty. This is not a reason to reverse direction, but for all concernedin developing countries, in the advanced countries, and of course investorsto embrace policy changes to build strong economies and a stronger world financial system that will produce more rapid growth and ensure that poverty is reduced. Characteristics of Globalisation Globalization/internationalisation has become identified with a number of trends, most of which may have developed since World War II. These include greater international movement of commodities, money, information, and people; and the development of technology, organizations, legal systems, and infrastructures to allow this movement. The actual existence of some of these trends is debated. 1. Economically Increase in international trade at a much faster rate than the growth in the world economy Increase in international flow of capital including foreign direct investment Creation of international agreements leading to organizations like the WTO and OPEC Development of global financial systems Increased role of international organizations such as WTO, WIPO, IMF that deal with international transactions Increase of economic practices like outsourcing, by multinational corporations 2. Culturally Greater international cultural exchange, Spreading of multiculturalism, and better individual access to cultural diversity, for example through the export of Hollywood and Bollywood movies. However, the imported culture can easily supplant the local culture, causing reduction in diversity through hybridization or even assimilation. The most prominent form of this is Westernization, but Sinicization of cultures also takes place. Greater international travel and tourism

Greater immigration, including illegal immigration Spread of local foods such as pizza, Chinese and Indian food/Pakistani Food to other countries (often adapted to local taste) World-wide Fads and Pop Culture such as Pokmon, Sudoku, Numa Numa, Origami, Idol series, YouTube, MySpace, and many others. Increasing usage of foreign phrases. Example... "Amigo" and "Adios" are Spanish terms many non-speaking spanish people in the US understand, Most Americans understand some French, Spanish or Japanese without actually knowing the language. Development of a global telecommunications infrastructure and greater transborder data flow, using such technologies as the Internet, communication satellites and telephones Increase in the number of standards applied globally; e.g. copyright laws and patents Formation or development of a set of universal values The push by many advocates for an international criminal court and international justice movements (see the International Criminal Court and International Court of Justice respectively). It is often argued that even terrorism has undergone globalization, with attacks in foreign countries that have no direct relation with the own country.

Gains/Advantages and Disadvantages of Globalization: In Short, the various advantages and disadvantages of globalization are as follows. Some Advantages i. Increased free trade between nations ii. Increased liquidity of capital allowing investors in developed nations to invest in developing nations iii. Corporations have greater flexibility to operate across borders iv. Global mass media ties the world together v. Increased flow of communications allows vital information to be shared between individuals and corporations around the world vi. Greater ease and speed of transportation for goods and people vii. Reduction of cultural barriers increases the global village effect

viii. ix. x. xi.

Spread of democratic ideals to developed nations Greater interdependence of nation-states Reduction of likelihood of war between developed nations Increases in environmental protection in developed nations

Some Disadvantages i. Increased flow of skilled and non-skilled jobs from developed to developing nations as corporations seek out the cheapest labor ii. Increased likelihood of economic disruptions in one nation effecting all nations iii. Corporate influence of nation-states far exceeds that of civil society organizations and average individuals iv. Threat that control of world media by a handful of corporations will limit cultural expression v. Greater chance of reactions for globalization being violent in an attempt to preserve cultural heritage vi. Greater risk of diseases being transported unintentionally between nations vii. Spread of a materialistic lifestyle and attitude that sees consumption as the path to prosperity viii. International bodies like the World Trade Organization infringe on national and individual sovereignty ix. Increase in the chances of civil war within developing countries and open war between developing countries as they vie for resources x. Decreases in environmental integrity as polluting corporations take advantage of weak regulatory rules in developing countries.

FOREIGN DIRECT INVESTMENT Foreign direct Investment is direct investments in productive assets by a company incorporated in a foreign country, as opposed to investments in shares of local companies by foreign entities. It is an important feature of an increasingly globalized economic system. A Foreign company is one that has been incorporated outside India and conducts business in India. These companies are required to comply with the

provisions of the Indian Companies Act, 1956 as far as the Indian Operations are concerned. There are two types of foreign collaborations: a) Financial collaboration (foreign equity participation) where foreign equity alone is involved b) Technical collaboration (Technology transfer) involving licensing of technology by the foreign collaborator on due compensation.

INDIA - A DESTINATION TO INVEST

As rightly said by Sukomal C Basu, Chairman & Managing Director, Bank of Maharashtra ; India is the fourth largest economy in the world and has the second largest GDP among developing countries, in purchasing power terms. It is experiencing growth with macro economic stability and is in the process of integrating with the global economy. Far-reaching economic reforms initiated in July 1991 generated numerous business opportunities, leading to degeneration with removal of most licensing procedures. Today most sectors are open to foreign investment, and a government commitment to further opening of the foreign goods, services and investments. This step aims at rapid and substantial economic growth. A decade after launching free market reforms, the Indian economy is still a dot on the map when it comes to attracting foreign investment. Indian policymakers will put their best foot forward to try to showcase the attractiveness of Asia's third-largest economy. When it comes to luring foreign investment, India trails far behind China, which attracts $30-$40 billion annually. New Delhi, by contrast, draws a scant $3.0-4.0 billion.

"India can be a roaring tiger if all these problems are taken care of," Amit Mitra, secretary general of the Federation of Indian Chambers of Commerce and Industry (FICCI), told Reuters. "There are many positives. We have a stable external sector, a stable monetary and financial regime and a rejuvenated corporate sector ready to face the globalization challenge," said ICRA credit rating agency economic adviser Saumitra Chaudhuri. While India can boast of many positivesrising exports, growing industrial output, buoyant tax revenues and large foreign exchanges revenuesit also has a string of negatives. "We don't have the required infrastructure yet to absorb the kind of money flowing into China as foreign direct investment," said Nikhil Khattau, CEO of Sun F&C Asset Management, which has over 10 billion rupees invested in Indian markets. Analysts say the government must press ahead with aggressive privatization of state-run firms, deregulation, reform of archaic labor laws, and reduction of its huge fiscal deficit and lowering of tariff barriers that are still among the highest in the world. There are also other hurdles keeping the economy from realising its potential and leaving little room for credit rating agencies to upgrade India's ratings that are at junk levels. "Chinese policymakers are serious with whatever they set out to do, but somehow we tend to be non-serious when it comes to implementing policy decisions," said ICRA's Chaudhuri. However, India must improve its creaking infrastructure and revive reforms in the power sector if it wants to catch up with the economic challenge posed by China, which began its long march to the market in 1979, analysts say. "At present, we have an edge over China in software services, but if we fail to evolve and move up the value chain, even that position could be threatened," said Nikhil Khattau. India welcomes foreign investors with open arms with relatively few and specified exceptions. The key sectors where such prospects are available

are: Information Technology, Telecommunications, Transportation, Insurance and Financial services, Chemical, Petrochemical, Agriculture and food products, Oil and Gas Housing and constructions, Mining, Metals and minerals, Environment, Power and energy and Films etc. The process of economic reforms has made the Indian policies concentrate on attracting capital from abroad and making India a global industrial base. The resultant inflows of foreign direct investment and technology transfers have created an atmosphere for dynamic growth and increased competitiveness of Indian industry. Several multinationals have established their presence in the Indian market. While some of foreign companies have established operations in the country on their own, others have successfully teamed up with local companies and leveraged their presence in the country. Earlier, a more distinct multinational presence in non-core sectors such as consumer goods, intermediates and services was observed, primarily because the core sectors were reserved for the public sector. At present, foreign investment is being encouraged in the core sectors such as basic infrastructure. This has led to the entry of a large number of foreign investors in various sectors of Indian market, which include Fortune 500 companies, as well as small and medium enterprises (SMEs) from all over the world.

FOREIGN DIRECT INVESTMENT IN INDIA With the liberalization of the India economy, the large Indian market is being opened up to foreign investors. Several companies are setting up or have already set up operations in India to cater to the Indian market. Ever since liberalisation and industrial reform process started in the 1990's, the licensing and investment restrictions in various sectors have gradually been done away with. The Industrial policy resolution of 1956 and the statement on Industrial Policy of 1991 provides the basic framework for the overall industrial policy of the government of India. There are several strategies by which a foreign enterprise can set - up Indian operations.

Broadly, entry strategies may be classified into two major

types :-

A foreign investor may directly set up its operations in India through a branch office or a representative office or liaison office or project office of the foreign Company ; or It may do so through an Indian arm i.e. through a subsidiary company set - up in India under Indian laws. Foreign companies can set up their operations in India through opening of liaison, project and branch offices. Such companies have to register themselves with the Registrar of Companies (ROC), New Delhi within 30 days of setting up a place of business in India.

Foreign Direct Investment (FDI) is permitted as under the following forms of investments: 1. Through financial collaborations. 2. Through joint ventures and technical collaborations. 3. Through capital markets via Euro issues. 4. Through private placements or preferential allotments.

List of industries for which Industrial Licensing is compulsory:


Distillation and brewing of alcoholic drinks Cigars and cigarettes of tobacco and manufactured tobacco substitutes Electronic aerospace and defence equipment; all types Industrial explosives including detonating fuses, safety fuses, gun powder, nitrocellulose and matches Hazardous chemicals Drugs and pharmaceuticals

Forbidden Territories: FDI is not permitted in the following industrial sectors: 1. Arms and ammunition. 2. Atomic Energy. 3. Railway Transport. 4. Coal and lignite. 5. Mining of iron, manganese, chrome, gypsum, sulphur, gold, diamonds, copper, zinc. ORGANIZATIONS TO SUPPORT FDI IN INDIA Several organizations in India are there to support foreign players team up with Indian partners. These include the Confederation of Indian Industries (CII), federation of Indian Chambers of Commerce and Industry (FICCI), and several consulting firms. These organizations help the foreign investors to undertake viability studies of the projects and draw the entry strategies. Indian embassies abroad closely assist foreign investors in their initiative to participate in infrastructure projects in India. However there are two main boards in India without whose consent the FDI proposals are not valid. These are the Foreign Investment Promotion Board (FIPB) and the Foreign Investment Promotion Council (FIPC).

SHARE OF TOP INVESTING COUNTRIES OF FDI APPROVALS DURING THE YEAR : (Amount in million) 2002 Country No. of FDI approvals Rupees ( US $) %age share*

U.S.A.

542

20,511.2 (427.3)

18.55

Mauritius

219

18,466.1 (384.7)

16.70

UK

163

18,043.6 (375.9)

16.32

Japan

89

7,408.5 (154.3)

6.70

France

51

6,228.7 (129.8)

5.63

2001 Country No. of FDI approvals U.K. 162 Rupees ( US $) 49,942.5 (1,109.8) U.S.A. 589 49,215.3 (1,093.7) Netherlands 97 36,935.7 (820.8) Mauritius 239 28,925.3 (642.8) Japan 70 7,352.7 (163.4) Note : *Percentage share worked out after deducting the amount approved on account of ADRs/GDRs/FCCBs approvals during the year. 3.51 13.81 17.64 23.50 %age share* 23.85

SHARE OF TOP SECTORS ATTRACTING FDI APPROVALS DURING THE YEAR: (Amount in million) 2002 Sector No. of FDI approval s Services Sector (financial financial) & non108 16,475.1 (343.2) 14,996.1 (312.4) Electrical Equipment (including computer software & electronics) Telecommunications 78 625 14,172.2 (295.3) 11,287.5 (235.2) Fermentation Industry 5 7,904.2 (164.7) 7.10 10.13 12.72 13.46 14.79 Rupees US $) ( %age share

Transportation Industry 127

2001 Sector No. of FDI approvals Telecommunications 75 92,654.5 34.48 Rupees ( US $) %age share

(2,059.0) Fuels (power & oil refinery) Electrical Equipment (including computer software & electronics) Services Sector (financial financial) & non94 736 60 75,839.6 (1,685.3) 19,812.7 (440.3) 15,631.1 (347.4) 9,630.6 (214.0) 3.58 5.82 7.37 28.22

Metallurgical industries 25

MONETARY POLICY Definition Monetary policy refers to those decisions and measures of the monetary authority which influence money supply and thereby the rate of interest, so as to achieve some pre-determined targets. The central Bank of a country formulates and operates the monetary policy. Monetary policy in India refers to those decisions of Govt. & RBI which influence the money supply credit, interest rate & related factors like savings, investment, output, income & price. According to Prof. Harry Johnson, A Monetary Policy is a policy employing the Central Banks control of the supply of money as an instrument for achieving the objective of general economic policy. Meaning of Monetary Policy Monetary policy, generally, refers to those policy measures of the central bank which are adopted to control and regulate the supply of money, the cost and availability of credit in a country. Monetary policy consists of those monetary decisions and measures the aim of which is to influence the monetary system. According to Paul Einzig, an ideal monetary policy may be defined as the effort to reduce to a minimum the disadvantages and

increase the advantages, resulting from the existence and operation of a monetary sytem. Broadly speaking, by monetary policy is meant the policy pursued by the central bank of a country for administering and controlling countrys money supply including currency and demand deposits and managing the foreign exchange rates. The central bank of a country through its monetary policy manipulates the money supply, credit, government expenditure, and rates of interest in such a manner so that the monetary system may be benefited to the maximum extent.

Objectives of Monetary Policy: Economists have conflicting and divergent views as regard the objectives of monetary policy. Economists have from time to time mentioned different objectives of the monetary policy. In fact the objectives of monetary policy change according to the changes in the business activities an level of economic development. The common objectives of monetary policy are as follows: Stability of Exchange Rates. Most of the economics of the world today are open economies. These economies have maintained trade relations with other countries. International trade transactions take place on the basis of a fixed rate of exchange. Any change in the equilibrium rate of exchange will have deep repercussions on the balance of payments of a country. It is, therefore, essential to maintain stability in the exchange rates. In gold standard, the exchange rate stability was maintained through the automatic working of the system. Free movement of gold from one country to another helped in correcting the disequilibrium in the balance of payments, whenever and d wherever it arose. But, the country had to sacrifice the domestic price stability for the sake of stability in exchange rates. The gold standard was finally abandoned after World War I, and since then the objective of stability of exchange rates has lost its significance. However, in paper currency standard, stability of exchange rates is maintained through the device of devaluation or overvaluation of the currency, as the case may be. Now, in most of the countries the monetary policy is directed towards achieveing economic stability.

Price Stability . Economists like Gustav Cassel and Keynes argue that domestic price stability should be the main objective of central banks monetary policy. Violetn fluctuations in prices create the problem of inflation and deflation which cause enormous hardships to consumers, wage-earners and other factor-owners. Both post-war inflation and great depression of 30s have convinced the economists that the objective of monetary policy should be the stabilization of the domestic price level even if this stabilisation may mean destabilization of the exchange rates. The objective of price stability has been criticized on several grounds. Modern economists believe that the objective of monetary policy should not be restricted only to the price stability but to the stabilization of the economic activity at full employment level in the economy. Moreover, the term price stability is very vague. Price level may mean wholesale prices, retail prices, labour prices, and so on. The stabilization of general price level is compatible with rising or falling of individual prices. Above all, the objective of price stability ignores the realistic requirements of a dynamic society. Thus, on account of the aforesaid limitations the objective of price stability has lost its significance in present times. It is now resorted to along with the currently more important objective, i.e. full employment. Full Employment. Full employment refers to a situation in which all those who are able and willing to work at he prevailing rates of wages get employment opportunities. Full employment, however, does not mean complete or total employment. Even at full employment level 2% to 5% resources may remain unemployed. Various forms of unemployment like involuntary unemployment, seasonal unemployment, frictional unemployment and structural unemployment may exist at full employment level. It may not be very difficult for most countries to achieve the level of full employment but the real problem is how to maintain it in the long run. Periodical fluctuations in the business activities may cause unemployment in the economic system. The monetary policy, therefore, should be directed to ensure that current investment exceeds current saving and this can be done by creation of credit money or by the creation of additional bank deposits or by higher velocity of circulation. When full employment is achieved, efforts should be made to maintain equality between saving and investment at the full employment level. According to Crowther, the obvious objective of the monetary policy of a country should be to attain equilibrium between saving and investment at the point of full employment.

Economic Growth with Stability. While for most of the developed countries the objective of monetary policy is to maintain equality between saving and investment at ht full employment level, the monetary policy in the undeveloped countries is directed towards achieving high rate of economic growth. Monetary authority in an underdeveloped economy can use different tools to promote economic growth. Economic growth refers to a process whereby an economys real national income increases over a long period of time. By increase in real national income we mean more availability of goods and services in a country during a given period of time. Thus, economic growth means the transformation of society of a country from a state of under development to a high level of economic achievement. The main hinderance in economic growth is the lack of investment activities in the underdeveloped countries. Monetary policy can play a very crucial role in promoting the investment activities. Monetary policy can also discourage investment in less-productive or less-useful activities. In other words, monetary policy may be a mixture of cheap and tight monetary management, so as to encourage and discourage investment according to the requirement, so as to encourage and discourage investment according to the requirements of business activities. Besides, the monetary policy should also aim at maintaining stability in the economy. Monetary policy should be directed towards achieving high rate of growth over a long period of time.

Difficulties Encountered in Pursuit of objectives of Monetary policy OR Conflicting Objectives of MP. It is highly idealistic situation where MP can achieve all the objectives simultaneously. The various objectives of MP are interrelated but sometimes they conflict with each other. Some areas of conflicts are as follows: Economic Growth vs. Price stability: It is very difficult for MP authority to promote economic growth and price stability together. This is so growth requires investment which is done from savings, borrowings and deficit financing. As savings are not enough, government has t resort to deficit financing. It helps to exploit resources and

produce more output. Since there is a gestation period bet investment and output, inflation takes place. A mild inflation is good but it does not stop and keeps on increasing. Hence price stability is not consistent with growth. Economic Growth vs. Full Employment: Growth implies continuous increase in production of goods and services. It not only exploits the existing resources but also improves technology .Full employment is complementary to economic growth. It promotes growth and growth generates more employment. Fundamentally, there is no conflict. However growth could be better promoted with improved and capital intensive technology which may not generate employment. Achieving Full employment though necessary not always lead to optimum utilization of resources. Thus the conflict starts. Full Employment vs Price Stability: Full Employment and price stability are also incompatible objectives of MP. A restrictive MP is applied to control inflation but this affects the level of employment. On the other hand, an expansionary MP is applied to reduce unemployment but this has an adverse effect on the price level. Thus this conflict appears to be natural. It is explained by Philips curve hypothesis. Here, OC curve is Philips curve. It has negative slope. At point A, rate of inflation is OP, and unemployment is ON. As we switch from A to B, rate of inflation decreases to OP2 through restrictive MP, unemployment rises to ON2. Similarly the movement from B to A on OC curve shows that if MP is used to reduce unemployment rate from ON2 to ON1, inflation rises from OP2 to OP1. Economic Growth vs Exchange Rate Stability: Due to economic growth, import increase of capital goods and service inputs, Export increase very slowly during earlier stages of development. Hence there is disequilitrium in BOP which is serious as economic growth continues or devaluation of domestic currency artificial measures would reduce exports further and still worsen the BOP position. Thus, economic growth and exchange rate stability may find it difficult to go together. Conclusion:

The MP authority should strike a compromise between the various conflicting objects depending upon the economic situations and the priorities. In a developing or underdeveloped country, a MP can be used to promote economic growth with reasonable price stability.

Instruments of Monetary Policy. Quantitative Methods/ General Methods Quantitative Methods/ Selective Methods Introduction: MP aims at managing & controlling money supply. For this task it makes use of monetary instruments. MP is implemented by the monetary authority of the country which includes Central Bank of Country & the Government. Quantitative/ General Methods: These are used for regulating the flow of credit to all the sectors of the economy. They are used to stabilize the general price levels. Bank Rate Policy: Bank rate is the rate of interest charged by the Central Bank to all commercial banks while advancing money against (i) eligible securities such as govt.& other approved securities ii) rediscounting bills.(Providing credit to the banks is a part of Central Banks activities under its Lender of Last Resort function) When there is inflation, the Central Bank raises the bank rates. This will raise the cost of borrowings of commercial banks. So they will charge a higher rate of interest on loan given. At the same time, when rate is increased bank deposits from public will also increase leading to contraction of credit. When there is deflation, the Central Bank will lower bank rates. A reverse trend takes place leading to expansion of credit. Thus from above, we can say that during inflation central bank follows tight money policy by raising bank rate & thereby contracting credit. Open Market Operation: It refers to the act of buying and selling govt. securities by the central Bank. These securities are 1st class assets required by the commercial banks & securities in the open market & reverse trend takes place. Thus, this leads to credit contraction & expansion in open market.

Variable Reverse Ratio: Every commercial bank is required to keep some percent of its deposits as reserves with the Central Bank. This percent reserve requirement is variable. The central bank can vary the reserve ratio to either contract or expand the supply of money. During inflation, it raises reserve ratio of commercial banks. When there is depression, it lowers the cash reserve ratio of commercial banks. Thus raising the reserve ratio will lead the credit contraction & reduction in reserve ratio will lead to credit expansion. Qualitative/ Selective Methods: They are used to regulate the flow of credit of particular sectors of the economy. They are used to channalise credit to important & essential sectors. It prevents flow of credit to less important sectors. Marginal Requirement: Any loan sanctioned against the stock of commodities of securities is subject to a margin. Higher the margin, lesser will be the loan sanctioned. Amount of loan is equal to the value of assets minus the margin. If margin is 50%, only 50% of the value of asset will be sanctioned for loan. The Central Bank raises the margin to contact credits &lowers it to expand credits. Consumer Credit Control: Under this method, rules are laid down regarding payments and max maturities of installment credits for purchases of durable consumer goods. Higher initial payment and lesser number of installments will discourage the demands for loan. The reverse situation will increase the demand for credits. During inflation down payments is increased and the number of installments are reduced. This will lead to credit contraction. During deflation, the reverse is the case. Control through Directives: The Central Bank issues directives to commercial banks and ask them to follow certain principles in lending. Directives may be oral or written. Rationing of Credits: It refers to laying down a ceiling on the maximum amount of accommodations which the commercial banks can get from the central bank by way of discounts, assignments of credit quotas to each bank by prescribing a minimum ratio of capital of a bank to its total assets. This will limit the amount of loans given to each bank.

Direct Action: Direct Action is taken by the Central bank against those commercial banks that do not follow the MP laid by it. Moral Suasion: It refers to appeals, if necessary with the required amount of pressures by the Central Bank, to commercial banks to follow a certain line of action. Appeals may be in form of discussions, letters, proposals, etc. Conclusion: From above points, we can say that a tight MP by the central bank, helps to check the inflation and an expansionary MP helps to check deflation and thereby maintain price stability and equilibrium at full employment level.

Limitations of Monetary Policy in Developing Countries Monetary policy can play a very crucial and significant role in the economic development of developing countries. However, the success of the monetary policy is limited by certain factors, the more important amongst these are as follows: Underdeveloped Monetary and Capital Market. Most of the developing countries do not have a well-developed and fullyorganised money and capital market. In the absence of such developed money markets it is not possible to effectively implement the various credit control policies by the central bank. Lack of Integrated Structure of Rate of Interest. In the developing countries a sizable proportion of the total financial resources comes from the unorganized banking sector. In the absence of an integrated and well-organised structure of rate of interest the central bank fails to influence the market rate of interest through changes in the bank rate. In fact, any increase or decrease in the bank rate must be reflected in the form of increased or decreased market rate of interest, but it does not happen in the developing countries. Banking Habits of the People. In the developing countries most of the exchange transactions are conducted with the help of money.

People very seldom use credit instruments to perform exchange transactions. It is for this reason that the credit control policy of the central bank does not have desired effect on the business activities. Lack of Co-operation by the Commercial Bank. Commercial banks are the institutions which help in the implementation of the monetary policy pursued b ythe central bank. In developing countries, however, the commercial banks fail to provide sufficient co-operation to the central bank and in some cases they also flout the directives given by the central bank. Monetary policy cannot succeed unless and until there exists a proper coordination and co-operation between the central bank and commercial banks. Literacy and Social Obstacles. Most of the developing countries suffer from mass illiteracy, superstitions, dogmatism and other social evils. People do not understand the significance of banking institutions. Neither they keep their deposits with the banks nor do they avail the opportunities of loans and advances from the banks. The success of monetary policy depends upon the widespread banking institutions, banking habits of the people, adequate development of credit facilities, adequate quantity of bank deposits, entrepreneurial ability, etc. In brief, the monetary policy in a developing country suffer from several limitations. The monetary authority on the one hand, has to create conditions whereby the banking and financial institutions may flourish, and, on the other hand, it has to exercise various restrictions and controls to regulate the supply of current and credit in economy. The monetary authority has also to manipulate the credit policy in such a way as to step up saving and investment activities for accelerating the rate of economic growth. TRADE POLICY

Meaning of Trade Policy The mechanism through which the government interferes in foreign trade is referred as trade policy. It also influences the direction of development through influencing the pattern of investment. The government interference has wide implication on the economy. The trade policy is divided into free trade policy & policy of protection. Both these policies have their respective merits & demerits. Free Trade Policy

It does not place any restriction on movement of goods between countries. It is avsolutely free from any kind of artificial trade restriction such as tariff exchange control, quotas, etc. it implies a Laissez-Faire Policy. Under free trade policy the people have freedom to exchange their goods and services with goods and services of their choice irrespective of geo-political boundaries. Thus it is a policy of mom-interference by the government in the foreign trade. Arguments in favor of Free Trade ( Advantages ). Vent for Surplus: A country may have a surplus production of a commodity in which it enjoys comparative cost advantage. Such surplus will be wasted unless an outlet is found. Trade provides the requires marketing other countries. In the absence of such market the potential capacity will remain unexploited. Optimum Utilization of Resources: Free trade ensures optimum utilization of resources by avoiding its wastage. Every nation can specialize in production of only those commodities for which it is best suited. Thus the resources would be allocated to those goods which give comparative advantage. Preventing Monopoly Growth: free trade helps in preventing monopoly growth and exploitation of consumers due to the competition from abroad. Comparative Advantage: comparative advantage is the basis for international trade. Free trade helps the participating country to exploit the comparative advantage to the fullest. The country can concentrate on the production of the commodities which have low cost production. Social Gains: free trade enables contact with different nations. This helps in developing positive aspects like hard work & desire to save, ect. The demonstration effects helps in raising the standard of living. Increase in Employment, Income, Consumption: foreign trade requires more investment. According to its comparative advantage, each country would employ more people and increase the

production resulting in increase in income & consumption. Thus free trade leads to increase in standard of living & optimum economic welfare. Maximization of Output: in free trade all countries tend to specialize in the production of those commodities for which it is better suited. All trading countries together produce maximum possible output with minimum cost. Extends Market: it widens the size of the market. It includes investment and enables large scale production. It reaps the advantage of economies of scale and explorers of new markets. Political Understanding: it promotes international understanding and peace as it binds different countries. At the time of need, mutual help is extended. Help given is in the form of technology, financial aid, etc. it promotes friendly bonds between nations. Increase in National Income in encourages international capital movement and growth of industries. It enables import of technology, managerial talent, etc. this will increase production, NI and promote development of countries economy.

Protection Policy: Protection policy refers to a policy which puts restrictions in order to protect domestic industries in foreign competition. In encourages home industries by giving them subsidies or by imposing custom duties of foreign products. Devices such as tariffs, quotas, exchange control, dumping, state trading, subsidies, commodity agreement, etc. can be used in order to implement this protection policy. In brief, it implies use of deliberate measures to protect the domestic industries by promoting exports and restricting imports. Argument in Favor of Protection Policy The arguments in favor of protection policy are classified as: 1. Economic Arguments 2. Non Economic Arguments

Economic arguments Diversification of industry argument Economic development and modernization requires industrialization of the economy. If there is no diversified industrial sector, the growth becomes unbalanced. In the absence of home industries, a country may have to depend on imports. Promotion of industry is important to increase self sufficiency and for accelerating the development of agriculture. A policy of protection is required to maintain stability and protecting economy from foreign shocks, etc. it helps to diversify the structure of the industry. Hence for a balanced growth diversification of industries through protection is necessary. Infant industry argument: This argument was put forth by Alexander Hamilton, Fredrick List, etc. according to them an infant industry requires temporary protection against foreign competitors in order to make them capable to earn potential advantage. In developed countries an established industry is strong due to advantageous techniques and other economies of scale. Hence if free trade is advocated the domestic industry may not be able to compete foreign industries. Therefore government intervention in the form of protection is necessary in the early years of an industry. Anti dumping argument In free trade policy the foreign producers their goods in order to capture market in another country. The domestic industrialists in underdeveloped and developing countries cannot compete them due to diseconomies of scale. Protection policy is essential in order to stop dumping tactics used by foreign industries. Employment argument: This argument has been given by Jevons. Backward countries are over populated and indusial sector is also small. They are predominantly agricultural economies with low employment potential. Thus there is wide spread unemployment in such countries. Industries have large employment potential. With the growth of industries size employment also increases. The policy of protection stimulates industrialization and there by creates additional employment opportunities. thus protection policy shall be considered as an employment generating device.

Improving the Terms of Trade It is argued that the terms of trade can be improved by imposing import duty or quota. By imposing tariff the country expects to obtain larger quantity of imports for a given amount of exports, or conversely, to part with a lesser quantity of exports for a given amount ofim-ports. But the terms of trade could be expected to improve only if the foreign supply is inelastic. If the foreign supply is very much elastic a tariff or a quota is unlikely to improve the terms of trade, there is also the possibility that foreign countries will retaliate by imposing counter tariffs und quotas. The validity of this argument, is therefore, questionable. (iv) Improving Balance of Payments This is a very common ground for protection. By restricting imports, a country may try to improve its balance of payments position. The developing countries, especially, may have the problem of foreign exchange shortage. Hence, it is necessary to control imports so that the limited foreign exchange will be available for importing the necessary items. In developing countries, generally, there is a preference for foreign goods. Under such circumstances it is necessary to control unnecessary imports lest the balance ofi payments position become critical. Bargaining It is argued that a country which already has a tariff can use it as a means of bargaining to obtain from other countries lower duties on its . exports. It has been pointed out, however, that the bargaining lever, instead of being used to gain tariff concessions from foreign powers, may be employed by others to extract additional protection from the home government. National Defense Even if purely economic factors do not justify such a course of action, certain industries will have to be developed domestically due to strategic reasons. Depending on foreign countries for our defense requirements is rather foolish because factors like change in political relations can do serious damage to a country's defense interest. Hence, it is advisable to develop defense and other industries of strategic importance by providing protection if they cannot survive without protection. Key Industry Argument It is also argued that a country should develop its own key industries because the development of other industries and the economy depends a lot on the output of the key industries. Hence, if we 40 not have our own source of supply of key inputs, we will be placing ourselves at the mercy of the

foreign suppliers. The key industries should therefore be given protection if that is necessary for their growth and survival.

The arguments mentioned above have been generally regarded as 'serious'. There are, however, a number of other arguments also which have been branded as 'nonsense', 'fallacious', 'special interest', etc. Keeping Money at Home This argument is well expressed in the form of a remark falsely attributed to Abraham Lincoln: "I do not know much about the tariff, but I know this much: When we buy manufactured goods abroad we get the goods and the foreigner gets money. When we buy the manufactured goods at home we get both the goods and the money". As Beveridge rightly reacted, this "...argument has no merits; the only sensible words in it are the firsteight word." The fact that imports are ultimately paid for by exports clearly shows that the 'keeping money at home' argument for protection has no sense in it. Size of the Home Market It is argued that protection will enlarge the market for agricultural products because agriculture derives large benefits not only directly from the protective duties levied on competitive farn1 products of foreign origin but also, indirectly from the increase in the purchasing power of the workers employed in industries similarly protected. It may be pointed out against this that protection of agriculture will harm the non-agriculturists due to the high prices of agricultural products and the protection of industries will harm agriculturists and other consumers due to high prices encouraged by protection. Non Economic Argument: Defence Argument: It is very important to develop the defence industry in the country itself. For its defence needs, a country cannot depend upon external supplies especially during war and emergency. Therefore, the government should give full protection to enable these industries to develop. Each country should be sufficient in the defence equipment. Patriotism Argument: Protection is essential to wake and satisfy the patriotism of people. It is the duty of every citizen to prefer home made goods to foreign gods. The home made ones should be available in the right quality and quantity. This is not possible without such home industries being developed with the aid of protection.

Demerits of Protection: The following defects are generally attributed to protection: Protection is against the interest of consumers as it increases price and reduces variety and choice. Protection makes producers and sellers less quality conscious. It encourages domestic monopolies. Even inefficient firms may feel secure under protection and it discourages' innovation. Protection leaves the arena open to corruption. It reduces the volume of foreign trade. Protection leads to uneconomic utilisation of world's resources,

FISCAL POLICY Definition and Meaning: Monetary policy alone cannot achieve the objectives of sustained economic growth, stability and social justice in a developing economy. It is, therefore, essential to supplement the monetary policy by an effective fiscal policy. Monetary and fiscal policies taken together can prove to be very effective in achieving the objective of growth with stability. The two major tools of macro economic policy are fiscal Policy and Monetary Policy. The word fiscal originates from Greek word fisc which means a basket. The term fiscal is used to denote public purse that is revenue and spending operations of the public authorities. Fiscal operations include taxation, public expenditure and public debts. According to Otto Eckstein, fiscal policy is changes in taxes and expenditures which aims at short term goals of full employment and price level stability. According to R.A. Musgrave pure fiscal is measures which involves tax and/or expenditure action but which leave the structure of claims unchanged.

Constituents of Fiscal Policy:

The government can control an inflationary or deflationary situation in the economy by manipulating its fiscal policy. There are 3 main constituents of a FP: 1. Taxation policy (government revenue) 2. Public expenditure policy (government spending) 3. Public debts policy (government borrowings) All these must work together to make the FP sound and effective Objectives of Fiscal Policy: According to the level of economic development the objectives of a fiscal policy differs from country to country. In a developing economy the role of fiscal policy is to accelerate the rate of capital formation and investment, change the pattern of investment, maintain an adequate supply of essential goods, etc. following are the main objectives of a fiscal policy:1. Mobilisation of Resources. Most of the developing countries are caught in the vicious circle of poverty. Prof. Higgins remarks that the road to the growth of developing economies is paved with vicious circles. Vicious circle of poverty refers to the circular constellation of forces, tending to act and react in such a way as to keep a poor country in a state of poverty. The most important objective of fiscal policy in a developing country should be to break this vicious circle of poverty. In order to achieve the above objective it is of utmost importance to increase the rate of investment and capital formation to accelerate the rate of growth. The government may resort to voluntary and forced saving to collect enough resources for investment. Incremental saving ratio, i.e. the marginal propensity to save, can be maximized by a number of methods which may include direct physical controls, increase in the rates of existing taxes, imposition of new taxes, operating surplus of the public enterprises, public borrowings, deficit financing, etc. 2. Acceleration of Economic Growth. The aim of fiscal policy in a developing country is to accelerate the rate of growth so that the real national income of the country may increase in the long run. The government, through its taxation policy, public borrowings, deficit financing, etc., can provide incentives for saving and investment. The revenue resources collected through taxes should be invested in productive

activities. Public expenditure should be diverted towards new and more useful development activities. The government may also grant tax relief and subsidies to the entrepreneurial class to boost the investment activities. Expansion of investment opportunities will certainly have a favourable effect on the level of business activities and rate of economic growth. The poorer section of the society should be exempted from taxes. Growth breeds inflation. It is, therefore, essential to contain inflationary pressure in the economy through the curtailment of consumption expenditure and avoidance of unproductive investment. In developing countries, the level of per capital income is very low. As a result of this, adequate voluntary savings do not take place. The government, therefore, has to depend on taxation and public borrowings for raising revenue resources to finance development programmes. 3. To Minimize the Inequalities of Income and Wealth. To maintain the equality of income and wealth is not only an objective of economic growth, but a precondition to it. The government, therefore, should formulate its fiscal policy in such a manner so that it may reduce the inequalities of income and wealth. A mere increase in national income does not necessarily promote economic growth. It is all the more essential to reduce the existing inequalities of income and wealth. Extreme inequalities create political and social discontentment and generate instability in the economy. The following measures can be taken to reduce the inequalities of income and wealth: Progressive taxes may be imposed on the rich people so that the unnecessary consumption expenditure is curtailed. Luxury goods should be highly taxed and the proceeds so collected be diverted to productive investment activities. The government must spend more on the social services or on the items which benefit the poor people most. The fiscal policy must discourage unearned income. In brief, the problem of reducing inequalities of income and wealth may be solved through redistributive public expenditure and redistributive tax policy. 4. To Increase Employment Opportunities. One of the important objectives of fiscal policy in a developing country is to increase the employment was regarded as the most important objective under the influence of Keynes. Prof. Lewis is of the opinion that without

providing full employment to the available manpower, the objective of economic growth will remain incomplete. The government through her fiscal policy can help in creating and promoting an atmosphere where people may get employment opportunities. The government in a developing country can resort to the following methods to raise the level of employment in the country. (i) Public Spending. Public expenditure is the most potent weapon to fight against unemployment. The level of employment depends upon effective demand. The government can influence effective demand either by making more public expenditure or by resorting to such fiscal methods which may raise the level of private expenditure. The role of public expenditure becomes very significant during the period of depression when the private entrepreneurs are not keen to take up investment activities. The government can resort to counter cyclical fiscal policy, which means that taxes and government spending be varied in an anti-cyclical direction; government spending being cut and taxes increased in the expanding phase of cycle, and government spending increased and taxes cut during the contraction phase. Increased government expenditure will open new job opportunities in the economy, which mean creation of demand for goods and services. Mention may also be made of pump priming and compensatory expenditure to raise the level of employment in the economy, Pump priming refers to increase in private expenditure through an injection of fresh purchasing power in the form of an increase in private expenditure through an injection of fresh purchasing power in the form of an increase in public expenditure. It is argued that such an initial public expenditure may set in motion a process of recovery from the condition of depression. Pumppriming is based on the assumption that a temporary additional expenditure will generate lasting process to raise the level of employment and income. Compensatory expenditure, on the other hand, refers to the variations in the government budget expenditure to compensate the deficiency in private demand so as to maintain high level of investment, employment and income stability. In the words of Keynes, government expenditure becomes a balancing factor in order to maintain national income at a given level. Such an expenditure may be progressively raised during depression phase of the business cycle, and progressively reduced in the recovery phase. (ii) Taxation Policy. Taxation policy of the government can play a very important role in raising the level of employment in a developing economy. Unemployment is the result of low propensity to consume. The government

can resort to redistributive tax policy to remove the deficiency in the propensity to consume. While the rich people have a low propensity to consume the poor have a very high propensity. The government can impose heavy takes on the rich people and the proceeds of these taxes may be distributed among the poor. Progressive taxes on the rich persons are socially desirable and economically advantageous. It should, however, be noted that the progressive taxes should not adversely affect the inducement to save and invest. Similarly, the money transferred from the rich to the poor should not be wasted on conspicuous expenditure but utilized for essential consumption expenditure and investment. While explaining the effect of taxation policy o employment it would be pertinent to mention the idea of functional finance which was propounded by Prof. A. P. Lerner. The central idea behind the theory of functional finance is that fiscal policy be judged by its effects on the economy as a whole and not by any established doctrine of finance.

(iii) Public Debt Policy. Taxation policy does not prove to be very effective in the developing countries. People in these countries have a low level of per capita income, therefore, the scope of raising the tax rates or imposing fresh taxes is very limited. The government, therefore, has to resort to public borrowing to meet the various public expenditure obligations. Public debt policy can be used to control the non-essential private consumption expenditure and to raise small savings for financing the development expenditure. The government for this purpose can issue debentures, bonds, etc., with attractive rates of interest to encourage people to purchase these titles. In case the government fails to collect sufficient finance through these methods, it may resort to compulsory savings of the public. We cannot, however, depend very much upon public debt policy for raising the level of employment in a developing economy. Public debt will prove effective only when these debts are collected through the idle balance with the people. If the public borrowing results in a fall in current consumption expenditure or is financed through curtailment in investment, it will not have desired effects on the level of employment and income. 5. Price Stability. As we have already discussed, a developing country does not posses adequate capital resources of finance developmental expenditure. The scope of taxes and public borrowing is also limited. Therefore, the government has to resort to deficit financing. In most of the developing countries deficits in the States budget are met by printing more currency notes. Increase in the supply of money creates inflationary conditions in the economy. Increasing prices do not only create hardships for the wageearners and customers, these also raise the cost of development projects. Though some economists have favoured mild inflation as an incentive for capital formation, they have emphasized that large-scale inflation would retard economic growth.

FISCAL AND MONETARY INTERACTIONS The issues that arise in the coordination of fiscal and monetary policies in India can be understood by a brief review of the borrowing programmes of the Government. There has been a significant rise in government borrowing since 1971. The volume of treasury bills outstanding including those funded into special securities rose from Rs. 2,500 crores in March 1971 to Rs. 39,700 crores in March 1987. Other marketable debt

of the Central Government rose during the same period from Rs. 4,000 crores to Rs. 42,000 crores. Marketable debt of the State Governmetns too rose sharply from Rs. 1,200 crores in 1971 to Rs. 7,200 crores in 1986. Net Reserve Bank credit to Government also rose significantly from Rs. 3,800 crores in 1971 to Rs. 45,800 crores in 1987. Out of the increase in treasury bills and other marketable debt outstanding of the order of Rs. 81,900 crores, the absorption by the Reserve Bank accounted for about 60 per cent. The Reserve Bank owned more than 93 per cent of treasury bills outstanding in 1987. The developments mentioned above highlight two important features of the Government borrowing programme. First, the scale of borrowing was maintained at relatively high level and budgetary deficit represented by the increase in volume of treasury bills outstanding has gone up sharply. Government finances have come under increasing pressure in recent years. Surpluses on revenue account have given way to deficits. Interest payments as a proportion of tax receipts have shown a sharp rise to 35 per cent in 1992-93. Secondly, the market borrowings of the Government have generally been at lower than market rates even though the rates of return offered on other types of borrowings have been high taking into account the fiscal concession. The discount rates on treasury bills which had risen 4.6 per cent per annum in mid-1974 have been pegged at that level and even today remain at that level. Banks and the life insurance and general insurance enterprises are required to invest a prescribed proportion of the funds mobilized by them in Government securities commercial banks could not absorb fally the Government securities which were floated. As the earnings from holding these securities were not attractive and the banks had other alternative avenues for utilizing their funds more profitably, they held Government securities only to the extent they were required to hold them under statutory obligations. In these circumstances, the Reserve Bank of India, which manages the public debt, becomes the residual to Government securities and treasury bills. As Government incurred deficits every year, the question of retirement of treasury bills did not arise. The Reserve Bank had, therefore, to address itself to the difficult task of neutralizing to the extent possible the expansionary impact of deficits after taking into account the short-term movements ments in its holding of net foreign exchange assets the increasing liquidity of the baking system resulting from rising levels of reserve money had to be continually mopped up. The instrument of open market operations is not available for this task, given the interest rate structure. The task of absorbing excess liquidity in the system had to be

undertaken mainly by increasing the CRR. At some point, this can result in some crowding out of the credit to commercial sector. With frequent and sharp increase the CRR has reached its statutory limit. The forth budget deficits and their absorption by the reserve Bank highlight not only the close link between fiscal policy and monetary policy cut also the need for close coordination between the two. The essence of coordination between fiscal policy and monetary policy lies in reaching an agreement on the extent of expansion in Reserve Bank credit to Government year to year. This will set a limit on the extent of fiscal deficit and its magnetization and thereby provide greater manipulability to the monetary authorities to regulate the money. Its in this context that introduction of a system of monetary targeting mutually agreed upon between the Government and the central bank assumes added significance.

TRADE BARRIERS Trade Barriers Though there are a number of advocates of free trade, international trade is generally characterised by the existence of various trade barriers. Trade barriers refer to the government policies and measures which obstruct the free flow of goods and services across national borders. The main objectives of imposing trade barriers are: To protect domestic industries or certain other sectors of the economy from foreign competition To guard against dumping; To promote indigenous research and development; (iv) To conserve the foreign exchange resources of the country To make the Balance of Payments 'position more favourable; and To curb conspicuous consumption and mobilise revenue for the govern-ment. . Trade barriers may be broadly divided into two groups, namely, tariff barriers and non-tariff barriers (NBTs).

TARIFF BARRIERS Tariff in international trade refer to the duties or taxes imposed on intemationally lraded commodities when they cross the national borders. Tariff is a very important instrument of trade protection. However, mostly because of the efforts of the GATT/WTO aimed at trade liberalisation, in the Industrial countries, there has been a substantial reduction in the tariffs on manufactured goods over the last five decades, or so. In the developing countries although the tariff rates are still fairly high, many of them have also been progressively reducing the tariff levels. Tariffs are generally regarded as less restrictive than other methods of protection like quantitative restrictions. Therefore, organisations like the WTO generally prefer tariff to non tariff barriers. Classification of tariffs There are different ways of classifying tariffs. 1. On the basis of the origin and destination of the goods crossing the national boundary, tariffs may be classified into the following three categories: Export Duties An export duty is a tax imposed on a commodity originating from the duty levying country destined for some other country. Import Duties When a commodity is subject to both specific and ad-valorem duties, the tariff is generally referred to as compound duty. An import duty is a tax imposed on a commodity originating abroad and destined for the duty-levying country. Transit Duties A transit duty is a tax imposed on a commodity crossing the national frontier originating from and destined for other countries. 2. With reference to the basis for quantification of the tariff, we may have the following three-fold classification: Specific Duties A specific duty is a flat sum per physical unit of the commodity imported or exported. Thus, a specific import duty is a fixed amount of duty levied upon each unit of the commodity imported.

Ad- Valorem Duties Ad- Valorem duties are levied as a fixed percentage of the value of the commodity imported/exported. Thus, while the specific duty is based on the quantum of the commodity imported/exported, the ad-valorem duty is based on the value of the commodity imported/exported. Compound Duties When a commodity is subject to both specific and ad-valorem duties, the tariff is generally referred as a compound duty. 3. With respect to its application between different countries, the tariff system may be classified into the following three types: Single-column Tariff The single-column, also known as uni-linear tariff system, provides a uniform rate of duty for all like commodities without making any discrimination between countries.

Double-Column Tariff Under the double-column tariff system, there are two rates of duty on some or all commodities. Thus, the double-column tariff discriminates between countries. The double-column tariff system maybe broadly divided into (a) general and conventional tm4J and (b) maximum and minimum tariff The general and conventional tariff system consists of two schedules of tariffs the general and the conventional. The general schedule is l1xed by the legislature at the very start while the conventional schedule results from the conclusion of commercial treaties with other countries. The maximum and minimum system consists of two autonomously determined schedules of tariff-the maximum and the minimum. The minimum schedule applies to those countries who have obtained the concession as a result of the treaty or through MFN (most favoured nation) pledge unci the maximum schedule applies to all other countries. Triple-Column Tariff The triple-column tariff system consists of three autonomously determined tariff schedules-the general, the intermediate and the preferential. The general and intermediate rates are similar to the maximum and minimum rates mentioned above under the double-column tariff system. The preferential rate was generally applied in the case of trade between the mother country and its colonies. 4. With reference to the purpose they serve, tariffs may be classified into the following categories: Revenue Tariff Sometimes the main intention of the government in imposing tariff may be to obtain revenue. When raising revenue is the primary motive, the rates of duty are generally low lest imports be highly discouraged, thus defeating the objective of mobilising revenue for the government. Revenue tariffs tend to fall on articles of mass consumption. Protective Tariff Protective tariff is intended, primarily, to accord protection to domestic industries from foreign competition. Naturally, the rates of duty tend to be very high in this case because, generally, only high rates of duty curtail imports to a significant extent.

Countervailing and Anti-Dumping Duties Countervailing duties may be imposed on certain imports when they have been subsidised by foreign governments. Anti-dumping duties are applied to imports which are being dumped on the domestic market at a price either below their cost of production or substantially lower than their domestic prices. CounterVailing and anti-dumping duties are, generally, penalty duties as an addition to the regular rates.

Impact of Tariff Tariff affects an economy in different ways. An import duty generally has the following effects: Protective Effect An import duty is likely to increase the price of the imported goods. This increase in the price of imports is likely to reduce imports and increase the demand for domestic goods. Import duties may also enable the domestic industries to absorb higher production costs. Thus, as a result of the protection accorded by the tariff. the domestic industries are able to expand their output. Consumption Effect The increase in prices resulting trom the import duty usually reduces the consumption capacity of the people. Redistribution Effect If the import duty causes an increase in the price of domestically produced goods, it amounts to redistribution of income between the consumers and producers in favour of the producers. Further, a part of the consumer income is transferred to the exchequer by means of the tariff. Revenue Effect As mentioned above, a tariff means increased revenue for the government (unless, of course, the rate of tariff is so prohibitive that it completely stops the import of the commodity subject to the tariff). Income and Employment Effect:

The tariff may cause a switch over from spending on foreign goods to spending on domestic goods. This higher spending within the country may cause an expansion of domestic income and employment. Competitive Effect The competitive effect of the tariff is, in fact, an anti-competitive effect in the sense that protection of domestic industries from foreign competition may enable the domestic industries to obtain monopoly power with all its associated evils.

Terms of Trade Effect In a bid to maintain the previous level of imports to tariff imposing country, if the exporter reduces the prices, the tariff imposing country is able to get their imports at a cheaper price. This will, ceteris paribus, improve the terms of trade of the country imposing the tariff.

QUANTITATIVE RESTRICTIONS (QUOTAS) Quantitative restrictions or quotas are important means of restricting imports and exports. A quota represents a ceiling on the volume of imports/exports. In this section, we confine ourselves to quantitative restrictions on imports i.e. import quotas. Types of Import Quotas There are five import types of import quotas, including import licensing. Tariff Quota A tariff quota combines the features of tariff as well as of quota. Under a tariff quota, imports of a commodity upto specified volume are allowed duty free or at a special low rate, but any imports in excess of this limit are subject to duty/a higher rate of duty. Unilateral Quota In the case of unilateral quota, a country unilaterally fixes a ceiling on the quantity of import of the commodity concerned. Bilateral Quota A bilateral quota results from negotiation between the importing country and a pal1icular supplier country, or between the importing country and export groups withing the supplier country.

Mixing Quota Under the mixing quota, producers are obliged to utilise domestic raw materials upto a certain proportion in the production of a finished product. Import Licensing Quota regulations are generally administered by means of import licensing. Under the import licensing system, prospective importers are obliged to obtain a licence which is necessary to obtain the foreign exchange to pay for the imports. In a large number of countries, import licensing has become a very powerful device for controlling the quantity of imports either of particular commodities or aggregate imports.

Impact of Quota Like fiscal controls, quantitative restrictions on imports also have a number of effects on the economy. The following are, in general, the important economic effects of quotas. Balance of Payments Effect As quotas enable the country to limit the aggregate imports within specified limits, they help to improve the balance of payments position of the country. The marginal prosperity to import becomes zero when the Qota limit is reached. Price Effect As quotas limit the total supply, it may cause an increase in the domestic prices. Under quota, the price can rise to any extent because it places an absolute limit on the volume of imports and price determination if left to the forces of demand and supply in domestic market. Consumption Effect If quotas lead to an increase in prices, it may compel people to reduce their consumption of the commodity subject to quotas or some other commodities. Revenue Effect Quotas may also have a revenue effect. As quotas are administered by means of n licence, government may obtain some revenue by charging a licence fee. Protective Effect By guarding domestic industries against foreign competition to some extent, quotas encourage the expansion or domestic industries.

Redistributive Effect Quotas will also have redistributive effect if the fall in supply due to the import restrictions enables the domestic producers to raise prices. The rise in prices will result in the redistribution of income between the producers and consumers in favour of the producers. TARIFFS VERSUS QUOTAS Both tariffs and quotas have certain merits and demerits. Tariffs over Quotas 1. As a protective measure, quota is more effective than the tariff. Tariff seeks to discourage imports by raising the price of imported articles. However it fails to restrict imports when the demand for imports is price inelastic. Especially in the case of the developing countries, the demand for many imports is price inelastic. Quota, on the other hand, is very effective in restricting the imports within the required limits. 2. When compared to tariffs, quotas are much more precise and their effects much more certain. The reactions or responses to tariffs are not clear and accurately predictable but the effect of quota on imports is certain. 3. It has been argued that "".quotas tend to be more flexible, more easily imposed, and more easily removed instruments of commercial policy than tariffs. Tariffs are often regarded as relatively permanent measures and rapidly build powerful vested interests which make them all the more difficult to remove. 4. It has also been pointed out that quotas may also be employed as a measure to prevent the international transmission of severe recessions. Recession usually causes a decline in prices and this may encourage exports. A country may make use of quotas to guard against such recession induced exports into the country. Quotas, however, have certain defects and tariffs are superior to quotas in some respects. 1. The effects of quotas are more rigorous and arbitrary and they tend to distort international trade much more than tariffs. That is why WTO condemns quotas and prefers tariffs to quotas for controlling imports. 2. Quotas tend to restrict competition much more than tariffs by helping impOliers and exporters to acquire monopoly power. If the import quotas are allocated only to a few

importers, it may enable them to amass fortunes by exploiting the market. Similarly, quotas tend to promote concentration among foreign exporters. Professor Kindleberger points out that "A significant difference between a tariff and a quota is that conversion of a tariff into quota which admits the same volume of imports may convert a potential into an actual monopoly and reduce welfare.

BALANCE OF PAYEMENTS Exchange Rate : Transactions in the exchange market are carried out at what are termed as exchange rates. The rate at which the currencies of two nations are exchanged for each other is called the rate if exchange. For eg, If 1 US dollor is exchanged for Rs 40 then foreign exchange rate is 1 US $ = Rs 40. It can be defined as the amount of foreign currency that may be bought for one unit of the domestic currency. In Foreign exchange market, there are a variety of exchange rate according to the credit instruments employed in the transfer function. The Foreign Exchange Market maily deals with thew following types of exchange transactions: Spot Exchange Market: When foreign exchange is bought ans sold for immediate delivery, it is called spot exchange. It refers to a day or two in which two currencies are involved. The basis principle of sopt exchange market rate is that it can be analysed like any other price with the help of demand and supply forces. Forward Exchange Market: Here foreign exchange is bought or sold for future delivery .ie. for the period od 30, 60, 90 days. Thus, the forward market deals in contract ffor future delivery. The price for such transactions is fixed at the time of contract, it is called forward rate. Forward Markets are useful to importers and exporters. The foreign exchange regulations of various countries, generally, regulate the forward exchange transactions with a view to curbing speculation in the foreign exchanges market. In India, for example, commercial banks are permitted to offer forward cover only with respect to genuine export and import transactions.

Forward exchange facilities, obviously, are of immense help to exporters and importers as they can cover the risks arising out of exchange rate fluctuations by entering into an appropriate forward exchange contract.

Arbritage Arbritage is the act of simultaneously buying a currency in one market and selling it in another to make a profit by taking advantage of price or exchange rate differences in the two markets. If the arbritage operations are confined to two markets onlyit is said two point arbritage. If they extend to three or more markets they are known as three point or multi point arbitrage.

EXCHANGE RATE SYSTEMS Broadly, there are two important exchange rate systems, namely the fixed exchange rate system and flexible exchange rate system. Flexible Exchange Rate System: Under the flexible exchange rate system, exchange rates are freely determined on open market primarily by private dealings, and they, like other market prices, vary from dayto-day. Under the flexible exchange rate system, the first impact of any tendency toward a surplus or deficit in the balance of payments is on the exchange rate. Surplus in the balance of payments will create an excess demand for the country's currency and the exchange rate will tend to rise. On the other hand, deficit in the balance of payments will give rise to an excess supply of the countrys currency and the exchange rate will, hence, tend to fall. Diagrammatical representation of exchange rate and quantity of foreign exchange

In the above figure, the equilibrium rate is at E. where the demand and supply curves interact. OR is equilibrium exchange rate when demand for the exchange is equal to its supply. OR1 and OR2 are not equilibrium exchange rates. At OR1, D>S ( ie R1H > R1G) and at OR2, S > D, ( R2B > R2A ). At R1 and R2, exchange rates there will be pressure on the prevailing rate to move towards the equilibrium exchange rate ie. towards point E. Thus, exchange rate, like any other price is determined by demand and supply forces in the foreign exchange market. Any change in demand and supply will result in change in exchange rate. Factors influencing the demand and supply in deremination of the Exchange rate: Demand for Foreign Exchange Foreign Exchange in a country is demanded by people who require foreign exchange for the following: 1. Import of good: Consumers as well as capital goods are imported from other countries. Foreign Exchange is demanded by people who import these goods. 2. Import of Service. Services rendered by other countries which include banking, insurance, transport, communication, educational service, etc. are required to be paid in Foreign Exchange.

3. Unilateral Payments. Donations, gifts, etc are one side payments without corresponding returns. Such payement screate a demand for Foreign Exchange. 4. Export of Caiptal. Repayment of debt, purchases of assets in foreign countries , etc all require Foreign Exchange Supply for Foreign Exchange Supply of foreign exchange in a country comes from the receipt of its exports. The main sources of supply are: 1. Export of Servies. Export service in various fields, tourist coming from other countries, communication, transport, insurance, etc are important service which earn and supply foreign exchange. 2. Export of Goods This constitutes a major source of supply of Foreign Exchange. Both size and price of exports depends on demand and supply and elasticity of goods. 3. Unilateral Receipts. Payments received in the form of donations, remittance from domestic working abroad, etc form a part of Foreign Exchange supply. 4. Import of Capital. Foreign Direct Investment and Portfolio investment , Repayment of debt by foreigners, all increases the supply of Foreign Exchange

Fixed Exchange Rates Countries following the fixed exchange rate (also known as stable exchange rate and pegged exchange rate) system agree to keep their currencies. at a fixed, pegged rate and to change their value only at fairly infrequent intervals, when the economic situation forces them to do so. Under the gold standard, the values of currencies were fixed in terms of gold. Until the breakdown of the Bretton Woods System in the early 1970, each member country of the IMF defined the value of its currency in terms of gold or the US dollar and agreed to maintain (to peg) the market value of its currency within:!: I per cent of the defined (par) value. Following, the breakdown of the Bretton Woods System, some countries

took to managed floating of their currencies while a number of countries still embraced the fixed exchange rate system. Advantages of Fixed Exchange Rate System The relative merits and demerits of the fixed and flexible exchange rate systems have long been a topic for debate. A number of arguments have been put forward for and against each system. The important arguments supporting the stable exchange rate system: Exchange rate stability is necessary for orderly development and growth of foreign If exchange rate stability is not assured, exporters will be uncertain about the amount they will receive and importers will be uncertain about the amount they will have to pay. Such uncertainties and the associated risks adversely affect foreign trade. A great advantage of the fixed exchange rate system is that it eliminates the possibilities of such uncertainties and risks. Especially the developing countries, which have a persistant balance of payment deficits, should necessarily adopt the stable exchange rate sys. Exchange rate stability is necessary to attract foreign capital investment as foreigners will not be interested to invest in a country with an unstable currency. Thus, exchange rate stability is necessary to augment resources and foster economic growth. Unstable exchange rates may encourage the flight of capital. Exchange rate stability is necessary to prevent its outflow. A stable exchange rate system eliminates speculation in the foreign exchange market. A stable exchange rate system is a necessary condition for the successful functioning of regional groupings and arrangements among nations. Foreign trade plays a very important role in case of a number of countries. As we have seen in the first chapter, for certain countries, the value ,of foreign trade exceeds GNP, while for others, the value of foreign trade is more than 50 percent of their GNP. Exchange rate stability is especially important for such countries to ensure the smooth functioning of the economy. Its absence will give rise to uncertainties and this would disturb the foreign trade sector and, thereby, the economy. A stable exchange rate system is also necessary for the growth of international money and capital markets. Due to the uncertainties associated with unstable exchange rates, individuals, firms and institutions may shy away from lending to and borrowing from. the international money and capital markets.

Disadvantages of Fixed Exchange Rate System: Fixed Exchange Rate has a great flaw in those countries with a large and persistent Balance of Payment deficits were losing gold and other foreign assets. This could not go on forever. Hence USA abandoned this system. The other countries facing problems of payment deficit found their international reserves dwindling, which forced them, devalue their currency, which had an inflationary potential. Another problem was the question as to what level exchange rate system should be fixed. The exchange rate would normally be fixed at an equilibrium level but it is difficult for government to find that level where demand equals quantity supplied. Further even if the exchange rate of foreign currency is fixed, it shall give another host of problems. That is if the foreign rate is fixed at a lower level there shall be a deficit in the BOP. And if it is fixed at a higher level there shall be a surplus in the BOP. Therefore in view of the above drawbacks and problems, the fixed exchange rate system has been given up despite its various advantages mentioned above.