Government, Foreign Trade and Foreign Exchange Rate Functions

1. Government, Foreign Trade and Foreign Exchange Rate Functions CHAPTER 7

2. 1. Significance of Government Expenditure • Inevitable to ensure governments’ existence • Instrument of fiscal policy • Component of AD

3. 2. Why Government? • To frame / execute / monitor law and order • To grant / protect property rights • To provide public goods & encourage merit goods • To check market failures • To promote economic growth and manage business cycles Thus, governments spend and tax

4. 3. Government Vs. Public Sector >Government ? >Public Sector ? 2. Why Government? > Government Vs. Public Sector

5. 4. Govt. Expenditure Components • Consumption of goods and services • Wages / salaries for government staff • Food / clothing / shelter for military and others • Office and facilities for government actitities • Investment spending • Infrastructure • Defence • Education / health / administration • Others • Transfer payments • Public debt interest & Pensions • Subsidies • Grants and aids – social security

6. 5. Determinants of Govt. Expenditure • Some consensus on government activities • Political  Autonomous: Fiscal policy instruments

7. 6. Govt. Revenue Components • Taxation • Central, state and local governments • Direct and indirect taxes • Progressive, proportional & regressive taxation • Tax – GDP ratio a measure of government size • Tax function T = t Y (7.1) • Laffer curve • - Fallacy of ceteris paribus

8. 6. Govt. Revenue Components – contd. Figure 7.1 Laffer Curve

9. 6. Govt. Revenue Components – contd. • Grants from donors: Autonomous • Profits of PSEs and fees on public services • Dis-investments in PSUs: Autonomous • Borrowings and money printing (debt): Autonomous

10. 7. Consequences of Government • Re-distribution of income • Pareto law • Behaviour of consumers / investors • Taxes/subsidies • Injections = Leakages identity • Automatic stabilizers • Keynesianmultiplier

11. 8. Foreign Sector: Significance • Measure of Globalization • Net exports a component of AD • Additional factor to promote growth • Additional tools of stabilization policy in terms of tariffs, quotas, exchange rate system and the exchange rate

12. 9. Foreign Trade • What are exports and imports ? • Trade barriers and policy • Exports of goods and services at FOB • Imports of goods and services at CIF

13. 9. Foreign Trade – contd. a. Why trade? • Broader consumption basket • Advantages of competition • Comparative advantage / specialization • Economies of scale • Consumers’ preferences => Not a zero sum game: “win-win” situation

14. 9. Foreign Trade Sector – contd. b. Trade barriers / facilitators • No trade regulation (ban) • Quotas (quantitative restrictions) • Tariffs (dis-incentives to import) • Export promotions • Tariff better !! • Consumers & producers’ surpluses • * Government tax revenue

15. D S PRICE f a e g b d h c i j S D o k l m n QUANTITY 9. Foreign Trade Sector – contd. Figure 7.2 Tariffs Versus Quotas

16. 9. Foreign Trade Sector – contd. c. Trade policy / globalization • Inward / outward looking • Current / capital account convertibility • Push / pull factors • Contagion effect • Infant industry • Foreign exchange risk, if it is flexible

17. 10. Income Identity & Saving - • Investment Gap * Income identity: Y = C + I + G + (X - Z) - (Ti - S) [Y + TP - C - Td ] + [Td + (Ti - S) – G - TP] - I = NX => Saving – investment gap: S - I = NX (7.2) Since, Net export = - net foreign investment I - S = Net foreign Investment = Net capital inflow

18. BoP Balance: Current a/c surplus = capital a/c deficit Thus, NX + NIA + NTA = Net capital outflow (NIA = net factor income from abroad and NTA = net transfers from abroad) Is trade/current a/c deficit good / bad? Good: Consumption/ investment more, inflation low Bad: External debt more but if it is due to good investment, no problem If we ignore NIA and NTA, S – I = NKO = NX 11. Balance of Payments Identity

19. 12. Determinants of Capital Flows • >NKI = f ( id – iw) (7.6) • f > 0 • Covered interest parity: • irupee - idollar = (F – S) / S (7.7) • Uncovered interest parity: • irupee - idollar = (E – S) / S (7.8)

20. S = f ( Y ) I = F ( r ) NKO = Ө ( r ) Where f1> 0 F1< 0 Ө1 < 0 13. Determinants of S, I and NKO

21. 14. Determinants of Trade (a) Exports • World income (+ve) • Relative price • Domestic price relative to world price(-ve) (Forex rate) • Trade barriers (-ve) , U ] (7.3) X = f [ Yw ,

22. 14. Determinants of Trade – contd. (b) Imports • National income / output (+ve) • Relative price • Domestic price relative to world price (+ve) (Forex rate) • Trade barriers (-ve) , V ] (7.4) Z = f [ Y,

23. X X X Relative Price Relative Price Relative Price X X X National Income National Income National Income Z Z N NZ N B B B C C C P P P R R R A A A NX NX NX X X X Z 0 0 0 Q Q Q 0 0 0 S S S Export/Import Export/Import Export/Import Export/Import Export/Import Export/Import 14. Determinants of Trade – contd. Figure 7.3: Export - Import Functions

24. (b) Imports 14. Determinants of Trade – contd. (c) Net exports • Income * World income (+ve) * National income (-ve) • Relative Price (-ve) • Other Factors , U, V ] (7.5) NX = [ Yw, Y,

25. 15. Effects of Foreign Trade • Injections - leakages identity • Exchange rate as an additional • instrument • Investment multiplier • Slope of AD curve

26. 16. Measures to Correct Trade Deficit • Devaluation • Price elasticities: Marshall-Lerner condition • External debt / over shooting theory • Reactions of trade partners / beggar thy neighbour • Pass through devaluation • J curve phenomenon / short and long run • Import substitution/ reciprocal trade • Protectionist policy: Tariff, quotas, bans • Capital a/c surplus / Selling forex reserves

27. 17. Time Path of Devaluation effects Figure 7.4: The J - Curve

28. 18. Foreign Exchange Rate System • Fixed exchange rate system • Hard peg: • Dollarisation • Currency union • Currency board • Peg to single / composite currency • Soft peg (Horizontal / crawling band) • Bretton Woods System

29. 18. Foreign Exchange Rate System – contd. • Floating exchange rate system • Clean / pure / or free float: No imbalance in BOP • Dirty / or managed float: - Sterilization - Asymmetric - India since 1993

30. 18. Foreign Exchange Rate System – contd. • Ideal system • International trilemma • Foreign exchange risk • Depends on • Relative Inflation rate • Trade / commodity concentration • Size / level of eco development • Degree of openness

31. 19. Determinants of Foreign Exchange Rate • (a) Real exchange rate is determined by the demand & supply of currencies: BoP theory (i) Demand for dollars (= supply of rupees) = imports of goods & services + exports of capital (ii) Supply of dollars (= demand for rupees) = exports of goods & services + imports of capital

32. 19. Determinants of Foreign Exchange Rate – contd. * While imports and exports of goods & services depend on the real exchange rate, those of capital depend on the real interest rate. * Accordingly, the D and S curves with respect to real exchange rate slopes downward and upward for goods and services, and shifts parallelly to right and left for capital movements, respectively. * In order to not to complicate the graph, D and S curves in Figure below are for combination of goods and services, and capital movements.

33. 19.Determinants of Foreign Exchange Rate – contd. D S Real Exchange Rate D S 0 Demand / Supply of dollars Figure 7. 5: BOP Theory of Forex Rate

34. 19. Determinants of Foreign Exchange Rate – contd. * At equilibrium, Demand for dollars = Supply of dollars Or,Zg+s + Xk = Xg+s + Zk Or, Xg+s - Zg+s = Xk - Zk (7.9) => NX = - NKI (7.10) *If managed float, RBI would intervene and affect D and S of dollars and there by real forex rate. * Role of forex reserves

35. 19. Determinants of Foreign Exchange Rate – contd. (b) Given the real exchange rate (e), nominal rate (E) is given by E = e [Pw / Pd] *Note that while real forex rate denotes the relative price of goods and services, the nominal forex rate gives the relative price of currencies.

36. 19. Determinants of Foreign Exchange Rate – contd. æ ö + 1 P ç ÷ = 1 e E ç ÷ + 1 P è ø 0 æ ö + 1 P ç ÷ = 0 E e ç ÷ + 1 P è ø 1 æ ö + 1 P 0 ç ÷ ç ÷ + 1 P è ø 1 • (c) Purchasing Power Parity (Relative inflation rate) * Law of One Price: (Rs. 100) = $10 or, E = Rs. 10 / $ => E = Price at home / price abroad (7.11) (E using direct quotation) * Note: E depreciation of rupee !! (7.12) (7.13) Et = Et-1 (7.14)

37. 19. Determinants of Foreign Exchange Rate – contd. æ æ ö ö 1 1 . . 02 02 e = Rs.10 = E e = Rs.10 ç ç ÷ ÷ 1 1 . . 10 10 è è ø ø * Numerical example: = Rs. 9.272  Appreciation of e @ 8% If = Rs. 10.784  Depreciation of E @ 8%  E (d) Relative growth rate It affects forex rate via its effect on net exports

38. 20. Four significant variables in international transactions • Relative inflation rate • Relative interest rate • Relative economic growth rate • Foreign exchange rate

39. 21. International Financial Institutions • > International financial institutions • IBRD / World Bank • IMF • WTO • Evaluation of their roles

40. 22. Conclusion • Significance of US dollar / Euro / Yen • Closed vs. open (small and large) economy: In a closed economy, real interest rate is determined by domestic S and I. In a small open economy, real i = world real i if capital flows freely, information is perfect, and bonds are homogeneous. Large economy is one which exerts influence on the world interest rate when capital is perfectly mobile. • Saving - investment correlation puzzle