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Re: free trade: a debate from MV



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To answer the question posed by MV, one has to go to the basics of
economics. It is actually very interesting to see the basic simplicity
of the mechanism in theory, though of course, one can quarrel a lot on
the assumptions and 'other factors'.
1.Let us look at concepts of demand and supply. To simplify matters, we
may first look at a single commodity, say, a vegetable in a single
country. We may begin by seeing what happens if the price of the
commodity changes, with all other factors remaining equal, with the
assumption that there are many players in the market. If the price
increases, buyers tend to demand less and the 'demand' reduces. If the
price increases, producers will find it better to produce this commodity
and hence 'supply' increases. If we draw a curve with price along
y-axis   and the quantity demanded along x-axis, we get what is called
the demand curve. As we have seen, this curve is a downward moving curve
as we look at it from left to right. (We have to carry on in the text
mode, otherwise, it would have been very simple to draw a curve and see.
For the serious minded, I would still advise to take a paper and a
pencil to draw, like I am doing right now while typing this.)  If we
draw the price along y-axis as before in the same units and the quantity
supplied along x-axis in the same units as before, it gives us an upward
moving curve, the 'supply' curve. These two curves meet at a point. The
price pertaining to that point is called the equilibrium price. If we
assume a point above the equilibrium point along the demand curve, the
price at this point is above the equilibrium price. The demand at this
point is lower than the equilibrium demand and the supply at this point
is higher than the equilibrium supply. Thus this point denotes a phase
in the market when there is too much supply, excesss stocks pile up,
there is a surplus in the market and suppliers will no longer find this
a comfortable position due to less enthusiasm among the buyers. They
will  have to reduce price as otherwise they cannot sell, price falls
and demand rises.  This trend will go on till the equilibrium point is
reached, as there are several buyers and several sellers. Similarly, we
may look at all the other three sides of the equilibrium point and find
that in a like manner, the situation will move towards equilibrium,
whatever be the initial point.
2.We may see what happens if 'other things change'. For example, our
commodity is apple and let  us assume that there is heavy snowfall in
Himachal Pradesh, damaging the apple crop. This lowers the supply at all
prices, thus the whole supply curve shifts to the left. Assuming the
demand to be same, we can draw the curves and see that the equilibrium
point now pertains to a higher price than before.  Thus supply curve
shifting leftwards results in a higher outcome of price. Such changes
can be brought about in the same fashion, by other factors like rise in
cost of inputs, rise in profits of other avenues like tourism industry,
etc., which will impact the supply of apples, as some farmers find it
more remunerative to go to hotel business than to cultivate apples and
cause leftward shift of the supply curve. Similarly, the supply curve
can shift to right if better technology is adopted by the farmers, which
will reduce their costs, and will have effect of reduction of
equilibrium price. Similarly, the demand curve can also shift as a whole
due to other factors, like people's tastes changing, people's general
levels of income rising or prices of other substitute options changing.
3.Let us see the role of US dollars in India, assuming only two
countries to be trading, as a simple model. Just as vegetables are
available in vegetable market and their prices are influenced by demand
and supply, same logic applies to US dollars in foreign exchange market.
A demand for dollars is created if we have to import some goods from US,
as payment has to be made in dollars to the american seller and hence we
have to buy dollars by using our rupees. Similarly, if I go to US and
stay in a hotel, I have to spend in dollars and therefore I have to
convert my rupees to dollars when I go to US and enjoy US services.
Similarly, demand for dollars is created if I invest in a software firm
in USA, as I have to make all payments there in dollars. Now, how are
dollars supplied?  Supply of dollars is dependent on american imports of
indian goods, american imports of indian services and american
investment in indian assets. For doing any of these three things, the
american partner will have to make payment in rupees and therefore he
supplies his dollars to exchange them with rupees. Just as we had drawn
curves for vegetables in the beginning, we may draw the rupee price of
dollar on y-axis and quantity of dollars demanded  and supplied on the
x-axis. These two curves meet at a point, called the equilibrium foreign
exchange price of a dollar in terms of rupees.
4. Now, the above is theory with the assumption that no other factors
played any role. What happens if  'other factors' start operating and
the whole demand curve shifts towards right? That would tend to make the
equilibrium price of dollar higher, making one dollar equivalent to more
and more number of rupees. This could happen due to anything that
increases demand for american goods and services. It could be due to
temporary factors like say, as an example, craze for american
chacolates. This could theoretically be countered in a few years if
indian chacolate companies do some technology upgradation and be more
competitive. It could also happen due to much long time frame events
like indian imports of american petroleum, as an example. It may not be
easy to counter the latter type of shifts in the demand curve of dollars
in indian foreign exchange market. Now, whatever be the nature of
factors causing rightwards shift of demand curve of dollars, Indian
government has the following four options:
A) The exchange rate may be maintained at the present level, and the gap
in number of dollars demanded and dollars available in the market by
taking out dollars from foreign exchange reserves of India and selling
them. Obviously, this can be done on a short-term basis, expecting the
situation to recover meanwhile, due the finite size of our foreign
exchange reserves.
B) Do nothing and let a dollar fetch 50 or 60 or whatever number of
rupees. That is, agree for devaluation of the rupee.
C) Have direct policies to reduce demand of dollars by putting quotas or
tariff restrictions on american imports to India, put limits on money
indian tourists can spend when they go to US or limit amount of american
assets Indians could legally be permitted to acquire.
D) Have restrictive monetary and fiscal policies, which will reduce
imports in an indirect way. Such policies will slow down Indian economic
activity and reduce incomes, by which consumption will fall, including
consumption of imported goods. Such policies will reduce inflation. As
the Indian goods become more competitive, import substitution will be
encouraged. Lower Indian inflation will also promote exports, as more
competitive indian goods enter american markets, americans buy indian
goods, demand for rupees will increase and thus, the gap between the
demand and supply in foreign exchange market will reduce. Thus this
option seeks to maintain exchange rate by changes in aggregate demand in
various nations.
Historically, before first decade of 20th Century, nations relied on
option D. This is the same as what came to be known  as the
international gold standard. To be on the gold standard, a country was
expected to maintain two conditions: 1. Monetary unit was to be defined
in terms of specific mass of gold. Authorities agreed to exchange paper
currency for gold or vice versa as per this rate.
2. Government must allow gold to be imported or exported freely. It
follows from these two conditions, if they are followed strictly, that
there is a third condition that gets followed, viz., each country should
permit its money stock to change proportional to the change in gold
stock. Thus in this option, an international adjustment mechanism
started operating, by which exchange rates are maintained by reducing
surplus or deficit in international payments.This is again a kind of
equilibrium procedure, which worked out in theory like this:  If India
is importing more from US than it exports, gold will flow from India to
US to pay for the excess of our imports. American money stock rises.
Indian money stock falls. In US, the aggregate demand and prices will
rise. In India, aggegate demand and prices will fall. As Indian goods
become cheaper, their exports rise, imports fall and indian gold
movement to US  will stop.
5. The gold standard system ran into problems, as the process of
adjustment as above proved to be very painful to deficit countries and
some times countries broke the rules of the game mentioned in para 4
above. Monetary system based on building large quantity of money on
relatively small base of gold led to vulnerability and major crisis of
confidence came during the depression in US in 1930's after which each
country backed out from the gold standard system.
In 1940's, the International Monetary Fund system was developed as a
compromise, permitting all options A, B, C and D. The operating basis
for the IMF 'adjustable peg system' was to allow US as the only country
to keep dollar convertible to gold and for all other countries, to
enable the country to hold its international reserves in gold, also in
foreign exchange i.e. dollars mostly and also by the contribution the
country makes to IMF, for which it gets an unconditional right to
withdraw anytime. This system stood the test of the second world war
period but over a period of time, US found that their imports were going
up as the value of dollar was relatively too high, because of
devaluation of currencies of other countries. Because of this reason, US
was unable to maintain convertibility of dollar into gold and this sytem
collapsed in 1971.
6. In 1973, the adjustable peg system gave way to what is called
flexible exchange rate system. Nowadays it is argued that exchange rate
stability is not a primary thing. Exchange rate changes have to be seen
as part of international adjustment process and aggregate demand polices
should be devised to stabilize a domestic economy rather than exchange
rate being seen as primary tool.  Thus in theory, how a country utilizes
the four options available is what determines exchange rate.
None of the above theory addresses the problems that I cited, as I am
concerned with not only foreign trade but also domestic trade, the
interests of socially marginalized poor people and their role in this
market world.


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