BASICS OF INTERNATIONAL FINANCE Ketki Bhirdikar Pushkar Borse Reema Rijhwani Shantala Samant

FISCAL POLICY

Meaning Fiscal policy is the use of government spending and revenue collection to influence the economy. It is the overall effect of the budget outcome on economic activity. Government uses it to regulate expenditure and revenue programme to produce desirable effects and avoid undesirable effects on the national income, production and employment. Operates through the annual budget.

Objectives 1) Price level stability 2) Desired consumption level 3) Desired employment level 4) Desired income distribution 5) Increase capital formation 6) Control Degree of inflation 7) To combat recession ( used by Kynes in 1930s in the Great Depression)

Instruments of Fiscal Policy 1. Public expenditure 2. Taxes 3. Public debts

Types And Tools Of Fiscal Policy FISCAL POLICY Discretionary policy To cure Recession Increase in Govt Expenditure Reduction of taxes To Control Inflation Raising Taxes to Control Inflation Disposing of Budget Surplus Non-Discretionary Policy Personal Income taxes Transfer Payments Corporate Income taxes Corporate Dividend policy

Discretionary Policy Deliberate change in government policy & taxation. Aims : 1. To cure recession. 2. To control inflation.

Non-discretionary Fiscal Policy No deliberate change made by the government. Automatically cures recession & controls inflation. Tools: 1. Personal Tax 2. Corporate Tax 3. Transfer Payments 4. Corporate Dividend policy.

Fiscal Deficit Government expenditure surpasses income. Normally expressed as a percentage of GDP.

Monetary Policy

Meaning Policy employing the central bank’s control on the supply of economic policy as an instrument of achieving the objectives of economic policy Influences publics liquidity position Monetary policy and credit policy

Objectives of Monetary Policy Feasible output High rate of growth Fuller Employment Greater equality in the distribution of income and wealth Healthy balance in balance of payments

Instruments Quantitative – 1. Open Market Operations (govtn securities) 2. Bank Rate Policy 3. Reserve Policy Qualitative – 1. Rationing of Credit (ceiling and penalty) 2. Changes in Margin requirement 3. Moral suasion

Problems Lag in results Presence of other financial intermediaries Contraction in objectives Underdeveloped nature of money and capital markets

Introduction to International Finance

The Gold Standard (Pre ) Rate at which one currency unit could be converted to a weight of gold ‘Fixed’ exchange rates Expansionary monetary policy limited to a government’s supply of gold Since WWI - free movement of gold interrupted Increasing fluctuation of currencies

Bretton Woods System ( ) Post WWII - US dollar was the only convertible currency US dollar based international monetary system was developed IMF and World Bank were created USD was fixed in terms of gold (USD 35 per ounce) Other countries fixed their currency relative to the USD

Floating Exchange Rates (1973 – ) Widely diverging monetary and fiscal policies, differential rates of inflation Growing demand for dollars Growing balance of payments deficit Subsequent devaluations of the dollar Exchange rates became more volatile and less predictable

Foreign Exchange Markets Market where different currencies are traded like commodities Exchange rate enables translation of prices of foreign goods into units of own currency Appreciation of a currency makes imports cheaper and exports expensive Depreciation of a currency makes imports expensive and exports cheaper

Exchange Rate Regimes Flexible rates Fixed-rate, unified currency Pegged exchange rates

Flexible Exchange Rate Regime Exchange rate is determined by supply and demand Demand for foreign exchange originates from imports Supply of foreign exchange originates from exports The foreign exchange market brings the quantity demanded and quantity supplied into balance

Fixed Rate, Unified Currency Regime A system where currencies are linked to each other at a fixed rate. The linkage may be through  use of the same currency  trade of currencies at a fixed rate Eg: European Monetary Union

Pegged Exchange Rate Regimes The country uses monetary and fiscal policy to maintain the exchange-rate value at a fixed rate or within a narrow band relative to another currency (or bundle of currencies) A nation can either:  follow independent monetary policy, allowing its exchange rate to fluctuate  tie its monetary policy to the fixed exchange rate It cannot maintain currency convertibility at a fixed rate while following a expansionary monetary policy

Balance of Payments Accounts that summarize the transactions of a country with foreign countries Current account balance Capital account balance Trade balance  Difference between exports and imports of goods and services  Trade balance = exports – imports

Trade Deficits The amount by which the value of imports exceeds the value of exports in a given time period It represents a net outflow of home currency to the rest of the world “Deficit” has negative connotations unless  attractive investment environment (net inflow of capital)  rapid economic growth (high imports)

Current Account Balance Current account transactions  Merchandise trade  Service trade  Income from investments  Unilateral transfers

Capital Account Balance Financial assets bought and sold across international borders  direct investments by foreigners  loans to and from foreigners –  Capital account balance Foreign purchase of U.S. assets U.S. purchases of foreign assets

Net Balance of Payments The capital-account surplus must equal the current-account deficit –  Net balance of payments current- account balance capital- account balance  0

Reserves of the Country IMF account Special Drawing Rights Reserve assets  Monetary gold  Foreign exchange reserves

DevaluationRevaluation Weakening of home currency Current account surplus Capital account deficit Called depreciation in floating system Strengthening of home currency Current account deficit Capital account surplus Called appreciation in floating system

Currency Convertibility Current Account Convertibility  Freedom to switch currencies to buy goods and services Capital Account Convertibility  Freedom to switch currencies to buy capital assets (bonds, shares)

Dimensions of CAC’s merits and demerits FDI inflow FDI outflow FPI inflow FPI outflow Inflation, exchange rates, interest rates

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