INTERNATIONAL TRADE AND FINANCE
IGNOU MEC 07 Solved Free Assignment
MEC 07 Solved Free Assignment July 2023 & January 2024
Q. 1. Critically discuss the Ricardian theory of Comparative Advantage. How is it different from Adam Smith’s theory of Absolute Advantage?
Ans. David Ricardo explains how a country can gain through International Trade even if the country does not have comparative advantage in any goods.
In that situation, he demonstrates in his comparative advantage theory how a country would benefit by comparative advantage.
To explain this theory, he has taken the example of England and Portugal. In Portugal it is possible to produce both wine and cloth with less labour than it would take to produce the same quantities in England.
So Portugal has absolute advantage in the production of both wine and cloth. So how can England gain from trade with Portugal?
Both England and Portugal would gain from trade and one can understand through the concepts of the opportunity costs manifested in comparative advantages.
For example, the cost conditions in the two countries are as given in the Table. So, Portugal has advantage over both wine and cloth.
If we calculate the opportunity costs, Portugal has lower opportunity costs (0.89) of the two countries in wine produc- tion, while England has lower opportunity costs (0.83) in cloth production. IGNOU MEC 07 Solved Free Assignment 2023-24
So, Portugal has comparative advantage over wine and England has over cloth and both the countries would gain if they export these respective products to the other country.
The pure theory of international trade is based on the concept of absolute advantage. According to Adam Smith, two countries can gain through international trade if they have absolute advantage in producing different goods.
What is absolute advantage? Absolute advantage is the ability of a country to produce more good or service than competitors, using the same amount of resources.
For example, Country A can produce 1000 parts of product X with 200 workers. Country B can produce 2500 parts of product X with 200 workers. On the other hand, Country A can produce 2500 parts of product Y with 200 workers.
Country B can produce 1000 parts of product Y with 200 workers. Here country A has the absolute advantage over Country B in producing product Y, while Country B has absolute advantage over Country A in producing product X.
So, if the country A exports product Y to country B and gets X from country B, both the countries will gain.IGNOU MEC 07 Solved Free Assignment 2023-24
Ricardian theory of Comparative Advantage: The classical theory of international trade is popularly known as the Theory of Comparative Costs or Advantage.
It was formulated by David Ricardo in his, “Principles of Political Economy and Taxation (1815)”.
The classical approach, in terms of comparative cost advantage, as presented by Ricardo, basically seeks to explain how and why countries gain by trading.
The idea of comparative costs advantage is drawn in view of deficiencies observed by Ricardo in Adam Smith’s principles of absolute cost advantage in explaining territorial specialisation as a basis for international trade.
Being dissatisfied with the application of classical labour theory of value in the case of foreign trade, Ricardo developed a theory of comparative cost advantage to explain the basis of international trade as under: Ricardo thought that, a country tends to specialise in and export those commodities in the production of which it has maximum comparative cost advantage or minimum comparative disadvantage.
Similarly, the country’s imports will be of goods having relatively less comparative cost advantage or greater disadvantage. Ricardo constructed a two-country, two-commodity, but one-factor model with the following Assumptions:
- Labour is the only productive factor.
- Costs of production are measured in terms of the labour units involved.
- Labour is perfectly mobile within a country but immobile internationally.
- Labour is homogeneous.
- There is unrestricted or free trade.
- There are constant returns to scale.
- There is full employment equilibrium.
- There is perfect competition.
Ricardo argues that if there is equal cost difference, it is not advantageous for trade and specialisation for any country in consideration.
On account of equal cost difference, the comparative cost ratio is the same for both the countries, so there is no reason for undertaking specialisation.
Hence, the trade between two countries will not take place. Ricardo emphasised that under all conditions, it, is the comparative cost advantage which lies at the root of specialisation and trade.IGNOU MEC 07 Solved Free Assignment 2023-24
Adam Smith’s Theory of Absolute Advantage: The trade theory that first indicated importance of specialization in production and division of labor is based on the idea of theory of absolute advantage which is developed first by Adam Smith in his famous book The Wealth of Nations published in 1776.
Later on David Ricardo in his book titled On the Principles of Political Economy published in 1819 extended it to incorporate theory of comparative advantage and showed that it is the basis why nations need to trade and why trade is mutually beneficial to countries.
Absolute Advantage: If a country or individual absolutely more efficient at production of a good than another country or individual, then we say that she has absolute advantage in the production of that good.
Comparative Advantage: If a country or individual is relatively more efficient in the production of a good than another country or individual then we say that she has comparative advantage in production of that good.
Comparative advantage measures efficiency in terms of relative magnitudes. Since countries have limited resources and level of technology they tend to produce goods or services in which they have a comparative advantage.
Comparative advantage (from now on CA) implies an opportunity cost associated with the production of one good compared to another.
That is why countries tend to specialize in production of certain products. This notion is called international division labor. The main assumptions of theory are:
- Factors of production cannot move between countries. This assumption excludes the possibility of migration between countries, as well as presence of multinational companies. It also imply that the PPF of each country will not change after the trade and there is no reason to expect wages (measured in the same currency) be the same after trade.
- No barriers to trade in goods.
- Exports must be equal to imports. This assumption means that we exclude trade imbalances, trade deficits or surpluses.
- Labor is the only relevant factor of production. Production exhibits constant returns to scale.
Q. 2. Explain the various concepts of terms of trade. Critically examine the behaviour of terms of trade as explained by Prebisch.
Ans. Terms of trade is the commodity terms of trade between the South and the North- the two regions. Terms of trade is (price exports)/(price imports) or the ratio of the prices of export commodities to the prices of import commodities.
For example, if the South exports 400 dollars worth of products and imports 200 dollars worth of products, its terms of trade are 400/200 = 2.
If multiplied by 100, these calculations can be expressed as a percent (200%). If a country’s terms of trade fall from say 100% to 70% (from 1 to 0.7), it has experienced a 30% fall in its terms of trade.IGNOU MEC 07 Solved Free Assignment 2023-24
Terms of trade are sometimes used as a proxy for the relative social welfare of a country or region, but this heuristic is technically questionable and should be used with extreme caution.
The increase of the ratio means an improvement in a nation’s terms of trade which is good for that country in the sense that it can buy more imports for any given level of exports.
The terms of trade is influenced by the exchange rate because a rise in the value of a country’s currency lowers the domestic prices for its imports but does not directly affect the commodities it produces.
There are a number of concepts related to terms of trade. These concepts are two types: those that relate to exchange between productive resources and those that relate to exchange ratios between commodities.
Net Barter Terms of Trade (NBTT): This is the price of exports to the price of imports, namely Pc/Pm = P, where Pc is the price of exports, and Pm is imports.
Single Factorial Terms of Trade (SFTT): This is the net barter terms of trade adjusted for the changes in productivity of exports. SFTT = PXOc where Oc is output per person in a country. IGNOU MEC 07 Solved Free Assignment 2023-24
The change in SFTT measures the change in living standard of an exporter in terms of imports. Suppose output rise but price declines and the total changes is zero, i.e., 6P+6OC-0, then the SFTT index will remain unchanged.
The Consumer Price index (CPI) will be PP where a is share of imports in the consumption basket. If E is money expenditure, then E/CPI is real expenditure when trade is balanced. So real expenditure will be:
As P fall, the real expenditure rose. But if there is no change in employment, there is a one to one relation between an output index and a productivity index, and the index for real expenditure per employed person, P.Q, is the Weighted Single Factorial Terms of Trade (WSFTT).
Double Factorial Terms of Trade (DFTT) is adjusted for both the productivity of imports and productivity of exports. DFTT is calculated to know the relative change in living standards. IGNOU MEC 07 Solved Free Assignment 2023-24
Thus, According to Prebisch, developing countries could not follow a development strategy on the basis of growth of the agricultural sector and export of the resulting higher output.
If they attempt to raise the growth rate of an economy, they would need a higher investment ratio and larger imports of capital goods because these countries do not have a large domestic capacity to manufacture capital goods.
Export earnings would rise only slowly as terms of trade would fall as more farm goods were exported.
Export earnings in results would be insufficient to fund the imports of capital goods, resulting in BoP problems and so efforts to increase the growth rate would not be effective.IGNOU MEC 07 Solved Free Assignment 2023-24
In a detailed statistical analysis, Prebisch gave his contention that the terms of trade of developing countries were deteriorating.
As he could not find data for the terms of trade of developing countries, he estimated the TT of the UK since the UK was an exporter of manufactured goods and an importer of intermediaries from developing countries.
Prebisch found that the TT of the UK had improved between 1870 and 1938 and thus he concluded that the TT of developing countries had deteriorated. This procedure followed by Prebisch was criticised on several grounds.
The UK’s TT does not represent the TT of developing counties since the UK’s NBTT is not representative of industrial countries as a whole. Thus, it is invalid to use the inverse of the UK’s TT for studying TT of developing countries.
The UK’s TT would not be correct data for study as the UK imported primary commodities from developed countries.
There are other factors like transportation costs which are responsible for fall in prices of imported products. IGNOU MEC 07 Solved Free Assignment 2023-24
In the UK may the prices of imports might have declined because of a fall in shipping costs since import prices include freight charges.
So the fall in import prices in the UK could occur without a decline in the prices of commodities exported by developing countries.
The usual method of calculation of price indices may be biased as it does not take account of introduction of new goods and quality differences.
Besides, economists did not find any evidence to support the view that the TT of the developing countries deteriorated in 1960s.
In a detailed analysis, Sparos however concluded that the evidence of Britain’s NBTT (with regard to the developing countries) was not misleading though it gave an exaggerated impression of the magnitude of the deterioration.
Sparos presented with evidence that the prices of agricultural products exported by developed countries increased. IGNOU MEC 07 Solved Free Assignment 2023-24
This bolsters the argument that if the relative prices of primary products imported into the UK were falling this would be because of a decline in prices of primary goods imported from developing countries.
The evidence also does not support the argument that freight rates fell more sharply than prices of agricultural products except in the period 1900-08, and hence could not have caused an improvement in UK’s TT without causing a deterioration in TT of developing countries.
Spraos attempted to improve on the indices estimated by Prebisch. Taking into account, various import and export indices and changes in transport costs, he found that the basic conclusion of Prebisch-a decline in the TT of primary commodities – is sustained even though the rate of fall is somewhat slower than what Prebisch had estimated.
According to Grilli and Yang, the terms of trade of developing countries did not deteriorate much despite the decline in primary commodity prices.
They argued that developing countries had diversified their export baskets and the TT of developing countries would have deteriorated much more sharply if their development strategy had been based on growth of the agricultural sector.
Q. 3. Explain multilateral framework of international trade. Explain its main features.
Ans. A multilateral framework like the WTO, where the member countries allow import and export of goods and services among themselves, is definitely a suitable platform for developing countries to join with.
By becoming a member of it, a country will have opportunity to engage in import and export.IGNOU MEC 07 Solved Free Assignment 2023-24
Developing countries need to be a part of international trade more than developed countries. This is because they require foreign exchange to pay for essential imports such as technology, fuel, capital goods and industrial intermediates.
Developing countries also need markets in other countries to sell their goods and services. Thus, developing countries need such a multilateral trading system.
This multilateral framework also offers a better deal than any bilateral agreement for trade can provide. It also provides collective security.
The platform has mechanism for enforcement of rights and obligations and dispute settlement system to protect against unilateral actions of other countries.
A member gets the opportunity to learn from the experiences of other countries in the group and also influence the process to some extent.
A country remaining away from the group will get an image of an odd man out. So it is better to be a part of the GATT/WTO framework which has been in existence for nearly six decades now.IGNOU MEC 07 Solved Free Assignment 2023-24
Now a large number of the developing countries are members and many more are in the process of joining it. The developing countries are nearly four times in numerical strength in the WTO compared to the developed countries.
The developing countries have numerical strength. They are in a majority, but they are not able to shape the GATT/WTO in accordance with their needs and priorities.
They have problems such as: (i) structural problems, (ii) problem with specific rules, and (iii) unfavourable operation of some rules.
Structural Problems: Developing countries have different levels of development. So there are countries which can give and those which cannot. When the participating countries cover a wide range of levels of development, it is a problem.
The widening cycle of giving and getting bring ever increasing benefit to the strong parties, whereas the weaker ones will remain on the fringe as they have not much to provide.IGNOU MEC 07 Solved Free Assignment 2023-24
Problems with Specific Rules: Rules set for international trade sometimes operate against the development process in the developing countries.
WTO’s national treatment principle prohibits a country to offer any preferential treatment to a domestic product. For developing countries, such a rule may affect their process of development.
It restricts their efforts to encourage the use of a domestic product and thus inhibits them in encouraging domestic production. This WTO provision can hinder the industrialization process in the developing countries.
Problems with Implementation: Implementation of some of the rules by the developed countries is technically correct, but they do not serve the goal of free and fair trade.
For example, developed countries were supposed to cut their domestic subsidy in agriculture. They fulfilled their obligation of reducing some subsidy as per the rules, but they increased the quantum of total subsidy.
The agreement stipulates some subsidies that are immune from reduction. While reducing some subsidy that was to be reduced, they increased the subsidies that were immune from reduction, making the resulting total subsidy higher.
Q. 4. What are the various forms of economic integration? How is trade diversion different from trade creation? Elucidate.
Ans. Regional trading blocs are only one of the various forms of economic integration that existed in the world.
There are five types of economic integration: (i) Free trade area, (ii) Customs union, (iii) Preferential trading area, (iv) Economic and monetary union, and (v) Common market. IGNOU MEC 07 Solved Free Assignment 2023-24
In a free trade area, members move towards zero or near-zero tariff levels among them on substantially all trade. Members in a customs union have a common external tariff on products coming from outside the union.
In a preferential trading area, members grant tariff preferences among. Harmonization of various economic policies, including monetary policies, is effected in economic and monetary union.
In the case of common market, freer movement of factors of production is allowed. If these stages of regional integration adopted in sequence, depict deeper economic integration processes. IGNOU MEC 07 Solved Free Assignment 2023-24
However, countries have formed regional groupings without following the strict sequence of different stages of integration. The key objective for regional trade integration is trade creation and trade diversion.
DFTT (P/P)(0/0) where O is output per person in the North. This provides the relative value of the output of workers and combines relative prices and relative productivity. Change in relative living standards can be decomposed into employment, productivity and TT changes.
If we keep employment out of the picture then the remaining two factors of productivity and TT can be combined into the DFTT. But the DFTT gives an accurate measure of changes in the relative size of consumption baskets only in special cases (i) fraction of income spent on tradeable goods should be the same in the two regions (ii) the relative price component is trendless.
For the DFTT, relative real income of the South relative to the North is (E/PP)+E/PP where E* is the expenditure in the North. When trade is balanced E. P.Q, and EPQ, and this expression becomes (Q/Q*) P.
Under constant employment assumption, this converts to k Paa(Q/Q) where k is the constant ratio of persons employed in the two countries. k drops out when we view the last expression as an index. So, WDFIT-P(Q/Q)
The trade unweighted version corresponds to the case where a+a-1.
This condition is satisfied when the two countries have identical consumption patterns.
Income TT (P/P).ON=V/P
Where Ne is employment in the production of commodity, so that V is value of primary production. The given value of output measured in import prices. This is a useful measure as employment data to calculate O, is often not available.
Employment Corrected IT: As there is full employment in the North, in case of increased output in one sector, there will be not be an increase in total income as income in other sectors falls.
But this will not be the case in the South where due to unemployment output foregone elsewhere is zero. To take account of this, we can estimate the employment corrected DFTT, namely ECDFTT which equals:
Where V=PON is index of output of exportables valued at current prices.
This extends the index to all three dimensions and also gets rid of troublesome O, which can often not be calculated because of lack of data.
6) Because of unemployment in the South, analysts take interest over employment corrected WSFIT. ECWSFIT=
The income terms of trade are PON, namely, they correspond to the case where a=1, and so equal of exports, namely value of exports expressed in import prices.
where X is quantity
If employment is not constant, then we calculate the ECWDFTT, employment corrected relative income double factor TT, = PO (N/N)O
The Behaviour of the IT
In a development context, Prebisch revived the likely evolution of the TT, a feature of classical analysis, was resurrected. Scarcity of land in classical economics would results in a rise in primary prices and the terms of trade for primary products would improve.
In consequence, industrial investment would be unprofitable and economic growth would get halted and the economy would come to stationary state.
This line of argument in more recent times has been adopted by various environmentalists beginning with the Club of Rome analysis.
Trade creation happens in a regional trading bloc or a Free Trade Area (FTA) through preferential tariff concessions. A more efficient producer of the product supplies within the free trade area. IGNOU MEC 07 Solved Free Assignment 2023-24
Trade creation enhances a country’s welfare as imports replace high-cost domestic production.
Trade diversion is diverting trade away from a more efficient supplier outside the FTA towards a less efficient supplier within the FTA.
Trade diversion may cause a reduction in a country’s national welfare. Despite trade diversion national welfare increases in some cases.
With an example we will see how trade creation and trade variation happen. In the table given below production cost of a homogeneous product in three countries is given. IGNOU MEC 07 Solved Free Assignment 2023-24
Assume that the price of the good is determined by the production cost and tariffs will be the only source of divergence between price and cost.
If China levies a tariff of 100 per cent, imports from India will be available at 800, and imports from Pakistan will be 600. In such a situation, China would not import the good.
Suppose China and India form a customs union and impose 100 per cent tariff on imports from Pakistan, consumers in China will get indigenous products at a price of 500, imports from India at 400, and imports from Pakistan at 600.
In such a situation, China would import the good from India. This is called trade creation. It replaces relatively inefficient (high-cost) indigenous production with efficient (low-cost) imports from the partner country. It leads to welfare increase.
Suppose before the formation of a customs union China imposes a tariff of 50 per cent, then domestic goods will be available at a price of 500, imports from India at 600, and imports from Pakistan at 450.
A would import the good from the lowest-cost import source, that is Pakistan. In this context, if China and India form a customs union, consumers in China will get the indigenous products at 500 and imports from India at 400, imports from Pakistan at 450. IGNOU MEC 07 Solved Free Assignment 2023-24
China will switch imports from the lowest-cost supplier, Pakistan to the higher-cost supplier, India.
This is called trade diversion. Trade diversion takes place when a country shifts its source of imports from a more efficient country to a less efficient country due to the tariff- preferences in a customs union.
It entails a less efficient allocation of resources and thus leads to a lowering of welfare.
Q. 5. Describe the evolution of international monetary system. Examine the trends in the international monetary and financial systems.
Ans. International monetary system is part of the international financial system which is defined as a set of global financial markets, global financial institutions, official lenders such as the IMF, and global regulatory arrangements.
These institutions facilitate cross border transactions in financial instruments.
International monetary system is interdependent in the sense that balances of payment are connected together. If one country has a balance of payments surplus, the rest of the world has a balance of payments deficit and vice versa.
If one country has a balance of trade surplus, the rest of the world has a balance of trade deficit. This influences the exchange rate system.
In a world of n countries with n currencies, there are n-1 independent exchange rates. No country can fix exchange rates on its own.
As we learnt that the problem of what is widely known as the “impossible trinity” will be there with the prevalence of cross- border capital flows.
It is impossible to achieve simultaneously the objectives of a fixed exchange rate, an open capital account and a monetary policy dedicated to domestic economic goals.
The fixed exchange rate system in various countries was dropped as an objective worth pursuing. The IMF had managed the anchored dollar system of fixed exchange rates. IGNOU MEC 07 Solved Free Assignment 2023-24
Since 1971 and especially after 1973, the year the international monetary system moved towards flexible exchange rates, the IMF lost its role as a guardian of the international monetary system.
The IMF was then shifted from its role at the centre of the international monetary system to a new role of ad hoc macroeconomic consultant and debt monitor.
When the gold exchange standard broke down as a price-stabilization mechanism through the inter-dependence of the currency system, there was inflationary pressure witnessed worldwide.
In results, the Articles of Agreement of the IMF were amended in 1978 with a focus how on price stabilisation as imbibed in the amended Article IV.
In 1971, the US decided to de-link the dollar from gold. Regarding role of the Fund, it is amply clear that the international monetary system was being run by industrialized countries. The Fund had no coherent system for monetary stabilisation to offer.IGNOU MEC 07 Solved Free Assignment 2023-24
In the strict sense, an international monetary system does not currently exist. Every nation has its own monetary system. The functioning of the IMF has been severely criticised.
Its credentials have also been questioned with regard several issues including IMF-supported programmes that impose austerity on countries in financial crisis.
Various trends are prevailing in the international monetary and financial system. Some of them are give below:
Globalization of financial markets and institutions: Financial markets and institutions are setting up their branches all parts of the world. There is no border or territorial barriers now.
Firms and financial institutions raising funds through foreign capital markets: MNCs and financial institutions are going overseas to sell their financial instruments to raise funds.
Foreign corporations and financial institutions are also now allowed to issue bonds and stocks denominated in different currencies. They are also allowed to buy domestic securities.
Emergence of international financial centers in Europe and Asia: A number of financial centres have opened in Western countries.
. Growth of offshore money and capital markets: Example is markets for Eurobonds.
Globalisation of insurance, banking and other intermediation businesses: Banks and insurance firms have opened branches all over the world.
Q. 6. Discuss the various instruments of trade protection. Differentiate between quotas and tariffs.
Ans. The tools of trade protection can broadly be divided into two types: (i) price-related measures or tariffs and (ii) non- price related or non-tariff barriers (NTBs). Here we will discuss the both measures in detail.
Tariffs: A tariff is a tax on imported products including both final and intermediate goods. This is called import duty. It changes the prices of imported goods and domestic goods. IGNOU MEC 07 Solved Free Assignment 2023-24
Tariff may be specific or ad valorem. Specific tariffs are fixed amount levied on a product, for example, Rs. 200 on 100kg of rice. Ad valorem are fixed percentage of the total value of the goods, for example, 20% tax on imported furniture.
Effect of a Tariff
In Figure, the impact of tariff on consumers, producers and the government is shown. It is a partial equilibrium framework.
It is also assumed that the country is a small open economy that cannot affect world market prices. Tariffs only increase the prices in the domestic market.
In Figure, D is the domestic demand and S is the supply curves of the imported product. P is the world market price of the product and this rate will be there in the domestic market under free trade. Q, is the domestic production of the production, Q, is the domestic demand and Q, Q, is the quantity of imported products.
The tariff imposed on the product is 1. Thus, the cost after the tariff is (P+1). In consequence, domestic production rises from Q, is Q,, while consumption declines from Q, is Q,IGNOU MEC 07 Solved Free Assignment 2023-24
Because of the tariffs, domestic consumers suffer a loss in consumer surplus equal to the area (a+b+c+d) compared to free trade.
The loss occurs as consumers must now pay more (P+) for the good and they now consume Q, Q, amount less of the good than with free trade.
The domestic producers however gain from the rise in prices. The area a in the graph is the increase in the producer’s surplus. The government also makes gains from the tariff. The tariff revenue is given by the area c.
It is clear that the loss to consumers is more than the gain to both producer and the government. This is shown in the graph’s b and d. This is also called a net social loss to society.
The loss in social welfare from the production distortion due to the tariff is area b. It is the higher costs of producing Q,Q, domestically instead of importing this amount.
The welfare loss due to the consumption distortion created by the tariff is area. It is the cost of not consuming Q, Q, an amount whose value to consumer exceeds the cost of importing it. IGNOU MEC 07 Solved Free Assignment 2023-24
In this analysis, impact on terms of trade, BOP and factor markets are not considered. It also does not attach any weight to employment in the sector being granted tariff production.
Non-Tariff Barriers: Non-tariff barriers are trade barriers that restrict imports but are not in the usual form of a tariff. Some common examples of NTBs are import quotas and export restrictions. Some of the NTBs are discussed below:
Quotas: An import quota is a type of protectionist trade restriction that sets a physical limit on the quantity of a good that can be imported into a country in a given period of time.
Quotas are applied through a system of import licenses. Firms which have license are permitted to import specified quantities of the imported good into the domestic market.
With a quota the domestic price of an imported good will always be higher than its world market price. Firms buy the product at world price and sell them at higher price in the domestic market.
Q. 7. Critically examine the relative merits and demerits of the fixed and flexible exchange rates.
Ans. On the basis of the experiences on the Bretton Woods system and the managed or dirty floating rate system since 1973, we will see the merits and demerits of the fixed and floating rates systems.IGNOU MEC 07 Solved Free Assignment 2023-24
Monetary Policy Autonomy: The Central Banks under fixed exchange rate system are obliged to intervene in the foreign exchange market to keep the rate fixed.
Such obligation is not there under floating rate regime. Thus, the government uses monetary policy to get internal and external balance.
Symmetry: The US was able to set world monetary conditions all by itself under Bretton Woods regime. Under floating rate system, it is different.
All the countries have the same opportunity to influence its exchange rate against foreign currencies.
Exchange rates as automatic stabilisers: For any rate alignment, there used to be long periods of speculation under Bretton Woods system.
Under floating rate system, policy-induced exchange rates were sought to stabilise the economies. Under floating rate, no long-period speculation is needed.
Discipline: Under the floating rate system, the Central Banks might engage in inflationary policies as they have the freedom to fix their exchange rates. This is not possible under fixed exchange rate regime.
Speculation: Speculation in change is rate under floating rate system may result in tremendous instability in foreign exchange market, effecting internal and external balance of countries.IGNOU MEC 07 Solved Free Assignment 2023-24
International Trade and Investment: The exchange rate under floating rate regime make internal prices more unpredictable and thus hit international trade and investment.
Uncoordinated Economic policies: There will be competitive currency practices under floating rate system. This may harm the world economy. Countries may adopt policies without taking into account the position of other countries.
Uncertainty: In floating rate, the exchange rate volatility increases. Floating exchange rate fuels greater uncertainty in the economy than the fixed exchange rate.