Theory of Comparative Advantage | XII – Class Banking Notes

Q.35. What are the assumptions and criticism relating to the theory of comparative advantage?

ASSUMPTIONS OF THE THEORY

The comparative cost theory is based on the following assumptions:

i. Labour is regarded as the sole factor of production and the cost of production only consists of labour cost.

ii. Production is subject to the law of constant returns.

iii. Factors of production are assumed to the perfectly module within a country but immobile between countries.

CRITICISM

The theory of comparative cost is criticized on the following grounds.

Assumption of Constant Cost

The classical economists were of the opinion that additional quantities & a commodity could be obtained with the same expenditure of cost per unit us previously But this is not valid assumptions lost ratios are subject to change where specialization between the two countries has gone a pace.

Some Static Assumptions

The comparative cost theory in a number of static assumptions of fixed costs industrial production functions between trading countries and fixed supply of land, labour, capital etc. It cannot be applied 100% to the real world.

Assumption of perfect mobility inside and immobility outside a country, these assumptions seems to be un-applicable to todays modern world of communication and technology the development of cheap quick and safe means of transport and communication has broken down this immobility to a great extent.

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Theory of Comparative Costs | XII – Class Banking Notes

Q.34. Explain in detail the theory of Comparative Costs.

INTRODUCTION

The classical theory of International trade commonly known as the principle of comparative cost was first enunciated by David Ricardo. The theory went through many additions improvements and refinements at the hands of economists like Mill, Cairns & Bastable.

An individual is able to perform many tasks but he does not perform them all. He selects that work which pays him the most. A doctor can also do the work of a dispenser but he does not do it. The same principle works in international trade. Considering the climatic conditions, distribution of material resources, geographical concern etc. Every country seems to be better suited for the production of certain articles rather than for others to employ its resources more remuneratively it will be to the advantages of

each country as well as to the world.

THEORY

In its simplest form the theory may be stated as, ‘’It pays countries to specialize in the production of those goods in which they possess the greatest comparative disadvantage.’’

EXPLANATION

Ricardo argued that two countries can gain very well by trading even if one the countries is having an absolute advantage in the production of both the commodities over the country. The condition is ‘’Provided the extent of absolute advantage is different in the two commodities in question’’ i.e. the comparative advantage is greater or comparative is lessees in respect of one good than in that of the other. In this connection we compare not the cost of production of one commodity with the other rather we compare the ratio between the cost of production of the two commodities concerned in one country with the ratio of their cost of production in the other country.

EXAMPLE

Suppose there are two countries A and B and there are two commodities wheat and rice. Suppose a unit of labour produces 10 tons of wheat or 20 tons of rice in country A. The same unit can produce 6 tons of wheat and 18 tons of rice in country B. According to this situation country A is having an absolute advantage in the production of both commodities over B. But she is at a greater comparative advantage in the production of wheat country B is at a disadvantage in both. Commodities the comparative disadvantage is less than case of rice. Hence the ratio would be

In A it is 10 : 20 i.e. 1 : 2

In B it is 06 : 18 i.e. 1 : 3

Therefore, A will specialize in wheat and B in rice and international trade will become possible and profitable. This is the law of comparative advantage or costs.

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Advantages and Disadvantages of International Trade | XII – Class Banking Notes

                                 

Q.33. What are the advantages of International trade? Also discuss its disadvantages.

ADVANTAGES OF INTERNATIONAL TRADE

Various advantages are named for the countries entering into trade relations on a international scale such as:

A Country may Import Things Which it Cannot Produce

International trade enables a country to consume things which either cannot be produced within its borders or production may cost very high. Therefore it becomes cost cheaper to import from other countries through foreign trade.

Maximum Utilization of Resources

International trade helps a country to utilize its resources to the maximum limit. If a country does not takes up imports and exports then its resources remain unexplorted. Thus it helps to eliminate the wastage of resources.

Benefit to Consumer

Imports and exports of different countries provide opportunities to the consumer to buy and consume those goods which cannot be produced in their own country. They therefore get a diversity in choices.

Reduces Trade Fluctuations

By making the size of the market large with large supplies and extensive demand international trade reduces trade fluctuations. The prices of goods tend to remain more stable.

Utilization of Surplus Produce

International trade enables different countries to sell their surplus products to other countries and earn foreign exchange.

Fosters International Trade

International trade fosters peace, goodwill and mutual understanding among nations. Economic interdependence of countries often leads to close cultural relationship and thus avoid war between them.

DISADVANTAGES OF INTERNATIONAL TRADE

International trade does not always amount to blessings. It has certain drawbacks also such as:

Import Of Harmful Goods

Foreign trade may lead to import of harmful goods like cigarettes, drugs etc. Which may run the health of the residents of the country. E.g. the people of China suffered greatly through opium imports.

It May Exhaust Resources

Internation trade leads to intensive cultivation of land. Thus it has the operations of law of diminishing returns in agricultural countries. It also makes a nation poor by giving too much burden over the resources.

Over Specialization

Over Specialization may be disasterous for a country. A substitute may appear and ruin the economic lives of millions.

Danger of Starvation

A country might depend for her food mainly on foreign countries. In times of war there is a serious danger of starvation for such countries.

One country may gain at the expensive of Another

One of the serious drawbacks of foreign trade is that one country may gain at the expense of other due to certain accidental advantages. The Industrial revolution is Great Britain ruined Indian handicrafts during the nineteenth century.

It May Lead To War

Foreign trade may lead to war different countries compete with each other in finding out new markets and sources of raw material for their industries and frequently come into clash. This was one of the causes of first and second world war.

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International Trade | XII – Class Banking Notes

Q.32. Why do International trade take place?

OR

Q.32. What are the bases for international trade?

Some of the reasons that why do trade between different countries occur are discussed under the following heads.

NATURAL ENDOWMENTS

Differences in advantages of trade to different countries may arise because of natural reasons like geographical and climatic conditions. This lead to territorial division of labour and localization of industry. This different countries specialize in the production of different things.

HUMAN CAPABILITIES

People in some countries are physically more sturdy where as in others they are intellectually superior. Some have greater skill and dexterity thus the countries. Which do not possess these qualities try to share with them.

STOCK OF CAPITAL

Some countries have large stock of capital goods like U.K, U.S.A, etc. These gives an opportunity to the underdeveloped countries or those which lack these capital goods to exchange or trade them through the channel of distribution internationally.

SPECIALIZATION IN PRODUCTION

A country may have a comparative cost advantage in production in more than one commodity over other countries but produces only one commodity for the sake of specialization. It helps in improving the quality of production to a great extent.

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Short Notes-2 | XII – Class Banking Notes

Q.31. Define the following terms?

INTERNATIONAL TRADE

International trade refers to that trade that take place between a country and a number of countries of the world. In other words we can say that all the trading activities that take place across the national boundaries is called International or Foreign trade. It is effect is called balance of payments.

INTERNAL TRADE

Internal or Domestic or inter-regional trade is the trade between different regions in the same country. We can also say that all the trading activities that take place within a country is called Internal trade.

ABSOLUTE ADVANTAGE

A country due to its most favourable geographical conditions may have an advantage in the production of a particular commodity over other countries. This advantage is known as absolute advantage for that country over rest of the world. The absolute advantage results in a regular inflow and outflow of goods which gives rise to International Trade.

COMPARATIVE ADVANTAGE

When a country has an advantage of production and move than one commodity it prefers to produce only one commodity that is more advantageous for other. This advantage is calculated by comparing the different commodities that how much they paying commodity is selected and the country goes for specializing. This is known as comparative advantage.

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Adverse Balance of Payments | XII – Class Banking Notes

Q.30. Explain in detail that how are adverse balance of payments can be corrected?

METHODS OF CORRECTING AN ADVERSE BALANCE OF PAYMENTS

Following are same of the methods adopted for correcting and adverse balance of payments.

Improving the balance of trade through import restrictions & measures of export promotions

Since balance of payments becomes adverse because of excess imports over exports, so a country having such a problem must try to check imports either by total prohibition or by levying import duties so by a quota system. Another method may be import substitution i.e. trying to produce in the country what it currently imports. Exports can be stimulated by measures of export promotion granting subsidies or other concessions to industrialists and exports.

Depreciation of the Currency

If a country depreciates its currency it proves very helpful in increasing the exports of goods. The value of the home currency fall relatively to foreign currency hence the foreigners are able to buy move goods with the same amount of their own currency or for the same amount of goods they have to pay less in terms of their own currency than before.

Devaluation

A country can turn the balance of payments in its favour by devaluating her currency. In this case also the devalued currency will become cheaper in terms of the foreign currency and the foreigners will be able to buy move goods by paying the same amount of their own currency. The effect is the same as in the case of depreciation.

Deflation

Deflation means construction of currency. If currency is contracted then according to the quantity theory of money the value of the currency will rise or the prices will fall. When prices fall the country becomes a good country to buy in and not a good country to sell into Exports will also thus increase and imports will be checked and hence the balance of trade will become favourable.

Exchange Control

Under a system of exchange control, all exporters are asked to surrender their claims or foreign currencies to the central bank which pays in return the home currency, which the exporters really want. This available foreign exchange is rationed by the central bank among the licenced importers. Thus imports are restricted to the foreign exchange available. There is no danger of more goods being imported than exported.

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Balance of Payment | XII – Class Banking Notes

Q.29. Write a detailed note on Balance of Payments.

BALANCE OF PAYMENTS

Each nation periodically publishes a set of statistics that summarize for a given period all economic transactions between its residents and the outside world. This statistical statement is referred to as balance of payments. The accounts show how a nation has financed its internation activities during the reporting period. They also show that what changes have taken place in the nations financial claims and obligations with the rest of the world.

STANDARD PRESENTATION

The IMF has significantly worked with success to standardize the system and the form of presentation.

B.O.P – DOUBLE ENTRY ACCOUNT

The B.O.P used double entry accounting. Transactions are recorded as credits of the yield receipts from or claims against foreign owners. Credits are received for example by exports of merchandise, sale of securities overseas and rendering services to foreigners. Similarly, debits are recorded of transactions cause payments to foreigners e.g. importing goods, tourist expenses abroad, purchase of foreign bonds.

B.O.P – CURRENT ACCOUNT

The Current Account includes merchandise trade in good and International Services are termed as Invisible trade. There are four basic service components. Tourism, Investment, Private Sector, Services such as royalties, rent, consulting and engineering fees etc and Government services such as diplomatic and buildings and membership fees in international organizations.

B.O.P – CAPITAL ACCOUNT

The capital account has a long term and a short term sector. The long term amount shows the inflow and outflow of capital commitments which have a maturity longer than a year. Short term capital movement frequently have a maturity date from 30-90 days. Long term capital items generally include loans to and from other governments, financial support for development. Projects abroad and export financing. Short term capital include paying for international services, selling accounts etc.

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Balance of Trade | XII – Class Banking Notes

Q.28. Define Balance of Trade

BALANCE OF TRADE

Balance of trade refers to the difference in the value of imports and exports of commodities only i.e. visible items only. Movements of goods between countries is known as visible trade because the movement is open and can be verified by the custom officials with respect to balance of trade the following terminologies are important.

Balanced Balance of Trade

If during a given years exports and imports of the country are equal the balance of trade is said to be Balanced.

Favourable Balance of Trade

If the value of exports exceeds the value of imports the country is said to experience an export surplus or favourable balance of trade.

Un-Favourable Balance of Trade

If the value of imports exceeds the value of its exports the country is said to have a deficit or an adverse balance of trade.

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Direct and Indirect Methods Adopted of Exchange Control | XII – Class Banking Notes

Q.27. Compare the direct and Indirect methods adopted of exchange control.

COMPARISON OF DIRECT & INDIRECT METHODS

These methods of exchange control are known as indirect methods because they do not control the exchange rate but only influence it. On the others hands the direct methods of intervention, restriction and exchange clearing agreements have the effect of directly controlling the exchange rate or the foreign exchange market.

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Foreign Exchange | XII – Class Banking Notes

Q.26. How does a country controls its foreign exchange?

METHODS OF EXCHANGE CONTROL

Paul Einzig is his book exchange controls has mentioned as many as 41 different methods of exchange control. They can be categorized as

1. Direct Method

2. Indirect Method

They are discussed here as under.

1. DIRECT METHOD

The direct method are further classified as:

Intervention

For an effective control of foreign exchange rates and the foreign exchange market the government usually have a central authority i.e. the Central Bank that has the complete power to control and regulate the foreign exchange market. Under this method any body who either wants to purchase or sell foreign exchange he has to deal with the central bank. All the selling and purchasing transactions of foreign exchange is controlled by the central bank which helps it to adjust demand and supply of foreign exchange according to the need of the country.

Restriction

Exchange restriction is another powerful weapon of exchange control. It refers to the policy by which the government restricts the supply of its currencies coming into the exchange market. It is achieved either by one of the following methods.

i. By centralizing all trading in foreign exchange with central bank of the country.

ii. To prevent the exchange of national currency against foreign currency with the permission of the government.

iii. By making all foreign exchange transactions through the agency of the government.

Exchange Clearing Agreement

Under this method the countries engaged in trade pay to their respective central bank the amounts payable to their respective foreign creditors. The central banks they use the money in off setting the corresponding claims after fixing the value of the foreign currencies by common agreement. The basic principle is to offset international payments so that they have not to be settled through the medium of the foreign exchange market.

2. INDIRECT METHODS

The most commonly used direct method or tool of exchange control is the use of tariff duties and quotes and other quantative restrictions on the volume of international trade. By imposing tariff and quotes the demand for the foreign currency falls down in the case of restricting the imports.

Rate of Interest

Another method of indirect exchange is the rate interest. The rate of exchange is the result of demand and supply of each other currencies arising out of trade and capital movement. A high rate of interest in a country attracts short term capital from other countries that leads to a exchange rate for the currency in terms of other currencies goes up.

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Objectives Of Exchange Control | XII – Class Banking Notes

Q.25. Identify the objectives of exchanges control?

OBJECTIVES OF EXCHANGE CONTROL

The following are some of the objectives of exchange control.

To restore Equilibrium

The chief objective of exchange control is to restore equilibrium in its balance of payments. If a country finds that its balance of trade has been persistently unfavourable then it must do something set it right. The balance of payment must ultimately be made to balance.

To Protest Home Industries

Another objective of exchange control is to protect the home industry from unfettered competition from abroad if the people at home are more interested in purchasing foreign goods it will ultimately discourage the local producers to produce more. It will directly affect the National Income and the domestic Gross Product of the country.

To Conserve Foreign Reserves

To conserve foreign reserve is another major objective of exchange control. Every Country needs foreign exchange in order to maintain its stability monetarily in the present age. Also the countries need foreign exchange to make payments for their imports and to pay back their debts obligation. For this a country must have foreign currencies on their hand. If there is a deficiency of the foreign exchange it is going to affect its liquidity position internationally and its credit rating.

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Fluctuation in Rate of Exchange | XII – Class Banking Notes

Q.24. What are the causes of fluctuation in the rate of exchange of a country?

The rate of exchange fluctuates in the market due to interplay of demand and supply of currency of a particular country. This is the result of some of the following transactions.

BALANCE OF TRADE

The main reason for fluctuations in the rate of exchange of the currency is the value of imports and exports of a country. If the value of imports exceeds the value of exports the rate of exchange will lend downwards and vice versa.

FOREIGN INVESTMENT

Foreign capital investment in a country necessities the payment of dividends or interest to the investing countries. If the capital absorbing country is not in a position to pay such claims in foreign currency, the rate of exchange of that country will definitely fall down.

SERVICE CHARGES

Freight and Insurance expenses also fluctuates the rate of exchange of a country. If the importing country does not have her own shipping companies the transportation charges are to be paid to foreign ships. So the insurance premium in case is to be paid to foreign companies. This creates a demand of foreign currency and if the supply is limited the rate of exchange will fall.

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Rate of Exchange | XII – Class Banking Notes

Q.23(A). Define the term rate of exchange.

Q.23(B). Explain how the rate of exchange is determined?

RATE OF EXCHANGE

The rate at which the currency or monetary unit of one country can be exchanged with the monetary unit of other country is called the rate of exchange. In other words, the rate at which a unit of one country exchanges for the currency of another is the rate of exchange between them. It may be used to denote the system whereby the trading nations pay off their debts.

Determination of Rate of Exchange

The rate of exchange is determined under the following under the following money systems as:

Under Gold Standard

If two currencies are on gold standard and if their currencies are expressed in terms of gold i.e. a certain weight of gold then the rate of exchange is determined by reference to the gold contents of the two currencies. Suppose Pakistan and United States are on gold standard the rupee being equal to 10 grams of gold and dollar consisting of 50 grams of gold. The rate of exchange between the two countries will be

1 Rupee = 10/50 = 1/5 $ or 0.20 cents

1 Dollar = 50/10 = 5 Rupees.

Thus the rate of exchange is determined in a direct manner by comparison between the gold contents of the two countries. This rate of exchange is also known as Mint Par of Exchange. The actual rate in the foreign exchange market will be slightly different from the mint par to allow for certain expenses. However the actual rate of exchange between currencies will not depart much from the mint par and will move between the two points of export and import of gold. These points are called Gold Points.

Under Paper Currency Method

This phenomenon of exchange rates determination is also called Purchasing Power Parity Theory. No country in the world is rich enough to have a free gold standard. All countries nowadays have paper currencies. According to this theory the rate of exchange between two countries depend upon the relative purchasing powers of their respective currencies. Such will be the rate which will equate the two purchasing powers.

For example if a certain assortment of goods can be purchased for ₤ 1 in Britain and a Similar assortment of goods with Rs. 16 in Pakistan then the purchasing power of ₤ 1 is equal to the purchasing power of Rs. 16. Thus the rate of exchange according to purchasing power parity theory will be
₤ 1 = Rs.16

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Renewal and Retirement of a Bill of Exchange | XII – Class Banking Notes

Q.22. What is Renewal and Retirement of a bill of exchange?

RENEWAL OF THE BILL

Sometimes the drawee of the bill is unable to pay the bill on its agreed date or time. In such a situation the drawee can apply to issue a new bill subject to certain conditions after the agreement of the drawer. This issuance of a new bill for some new time is known as renewal of the bill. After the issuance of the bill the former is considered to be cancelled. But if the drawee again unables to pay the newly issued bill, the first bill with all its farmer conditions becomes payable and valid.

RETIREMENT OF THE BILL

Sometimes the drawee pays the bill before the agreed date enjoying the rebate which is provided to him for prepayment of the bill. This is known as retirement of the bill. The amount of the rebate depends upon the time left for payment and the amount for which the bill is drawn.

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