See discussions, stats, and author profiles for this publication at: https://www.researchgate.

net/publication/320274062

The Rise and Fall of Keynesian Economics

Presentation · April 2017

DOI: 10.13140/RG.2.2.31207.96161

CITATIONS READS
0 1,353

1 author:

June Zaccone
Hofstra University
17 PUBLICATIONS   3 CITATIONS   

SEE PROFILE

Some of the authors of this publication are also working on these related projects:

Globalization View project

Contemporary Political Economy View project

All content following this page was uploaded by June Zaccone on 08 October 2017.

The user has requested enhancement of the downloaded file.

 1

The Rise and Fall of Keynesian Economics

June Zaccone
Economics October 4, 2017

Abstract: There aren’t many geniuses in economics. John Maynard Keynes was one. He revolutionized the way we understand how the
economy works, and even how we measure its workings. Those who say "consumers are the main job creators" have absorbed a major
lesson of Keynesian economics But this is not the only one. Though our version has been called Bastard Keynesianism, it has helped to
stabilize the US economy and reduce unemployment in the postwar era. We saw this most recently during the financial crisis, yet the
theory remains controversial. Why? And what opened the theory to attack?

[Slide1] A gold bug newsletter in 2009 put John Maynard Keynes, the most important economist of the
20th century, in the category of wanton revolutionary, a belief shared by other conservatives:
Lord Keynes, along with Vladimir Lenin ranks among the most destructive forces unleashed by World War I. Keynes was a
Fabian socialist who provided intellectual cover for inflationism. He was more subtle than Lenin, more a termite than a thug.
He... author[ed] bogus economic theories that turned classical economics on its head, undermined Western values..., and enslave
us to this day. 1

It is far more plausible that he saved capitalism and liberal democracy. For example, Hitler’s policies had reduced
unemployment to 1% by 1936, while ours was still over 14%. 2 Of course, many capitalists don’t admit they need
saving, at least until a financial crisis. Ironically, the rejection of Keynes and market regulation in favor of
financial globalization, with its crises and austerity, has created conditions for an authoritarian world. 3 My plan is
to describe Keynesian theory and why it met opposition [Slide2] despite its success. Notice the wider swings of
output [black line] and longer recessions [shaded areas] before WW2. I’ll end with the neoliberal counterattack and
updates to Keynes.
Keynes was no socialist, Fabian or otherwise. A biographer reports that he “always thought of himself as a
man of the Left. But the Left to him simply meant the Liberal Party4..... [though] the emergence of a powerful
critic of Establishment policies from within the Establishment was a great boon to the Left.” 5 He was ambivalent
about capitalism. As his colleague Joan Robinson, described him, “Morally and aesthetically, capitalism disgusted
him, while at the same time he felt that the system was the ‘best in sight’ and must be defended.” 6 Though he was
clever at making money, he considered moneymaking merely a means of living “wisely, agreeably, and well,” 7 not
a goal. Pursuing money for its own sake he thought “a somewhat disgusting morbidity.” 8
An advocate of markets, Keynes didn’t dispute the answers to the traditional economic questions of what to
produce, how to produce, and who benefits. To those proposing state ownership of resources, he answered, "there
is no objection to be raised against the classical analysis of the manner in which private self-interest will determine
what in particular is produced, in what proportions the factors of production will be combined to produce it, and
how the value of the final product will be distributed between them," 9 though he considered inequality an
economic impediment. However, he was a practical problem-solver and shifted his position when he saw fit. When
Churchill sent Keynes a cable reading, “Am coming around to your point of view,” Keynes replied, “Sorry to hear
it. Have started to change my mind.” 10
 2

A key to understanding Keynes is that unlike most economists today, his major goal was to eliminate
unemployment: the “real problem, fundamental yet essentially simple…[is] to provide employment for
everyone.” 11 His target for unemployment is “the sort of level we are experiencing in wartime ... less than 1%.” 12
He objected to an economy which produced far less than it could, a waste which left millions unemployed in
economies where work is not merely social status, but livelihood.
He said,
“...the labor of the unemployed is available to increase the national wealth. It is crazy to believe that we
shall ruin ourselves financially by trying to find means for using it and that safety lies in continuing to
maintain idleness.” 13

Once full employment is achieved, markets can be allowed to work freely, and “there is no more reason to
socialize economic life than there was before." 14 However, another comment in his major work, The General
Theory of Employment, Interest and Money, suggested that a “socialization of investment,” including public-
private partnerships, might be necessary to secure full employment. 15
What was the economic orthodoxy against which Keynes was rebelling? It was what he had learned at
university and once used as a practitioner at the highest levels of British academia and government, especially the
British Treasury and as a Bank of England official. 16 What Keynes termed the “classical theory” assumed that the
economy can manage itself. Beset by recession—even the depression of the 1930’s—the economy soon rights
itself. This theory adopted Say’s Law: “supply creates its own demand,” meaning that whatever is produced can
be sold. 17 If there is a surplus of goods, prices fall, leading consumers to buy more and producers to make less. If
savers provide more funds than businesses are willing to invest, interest rates on loans fall, leading to more
investment and less saving. Same with unemployment—wages will fall, so firms hire more workers, while others
leave the job market. Involuntary unemployment, meaning unemployed workers willing to accept the going wage,
is impossible. Nothing need be done. In fact, doing anything will only make things worse. Economists believed
that problems of long-term unemployment arise only if wages are prevented from falling.
Preceding the 1930’s depression, there was too little union power to blame unions; too little regulation to
blame regulation; and too much government support of business to blame government for the disaster. Inequality
was at levels resumed only in the late 1990’s. As the Wall St. Journal described the Coolidge era in 1927, “Never
before, here or anywhere else, has a government been so completely fused with business.” 18
The unfortunate Herbert Hoover had, as a candidate in 1928, promised “a chicken in every pot and an
automobile in every garage,” chicken being a luxury then. 19 Instead, his Administration, faced with economic
collapse and deficits created by falling tax revenues, made depression worse by raising taxes in 1932—“the largest
peacetime tax increase in U.S. history.” 20 It is difficult to imagine now, given our enormous deficits, that there
was such a fear of the modest deficits of the 1930’s. State and local governments raised taxes, too. Hoover had
declared in June 1930: “The Depression is over.” 21 It of course continued until WWII. Roosevelt further increased
 3

taxes and cut spending in 1937. This was followed by recession within the Depression. The Federal Reserve
contributed to the fiasco by tightening credit. Clearly, Keynesian policy had not yet been firmly established.
How much did Keynes influence the New Deal? 22 Not a lot. Keynes had sent world leaders a version of
his policy by 1933, 23 and New Deal policy matched some of his recommendations: repair the banks, devalue the
currency, and build public works to stimulate the private sector. 24 But not in scale. When Keynes met President
Roosevelt just over a year later, he had decided that while the New Deal had commendably spent $2.8 billion on
the crisis, it was too little. In an open letter to the president, 25 he estimated that another $2.4 billion was needed
over the next six months—enough to raise the total to the $5 to $6 billion range that Roosevelt had rejected as
“wild.” Roosevelt told Labor Secretary Frances Perkins, “I saw your friend Keynes. He left a whole rigmarole of
figures. He must be a mathematician rather than a political economist.” 26 Roosevelt’s response was probably not
because he didn’t understand the math, but because he did—what was required was politically impossible. Keynes
had described to Perkins the effects of spending: “...a dollar spent on relief by the government was a dollar given to
the grocer, by the grocer to the wholesaler, and by the wholesaler to the farmer, in payment of supplies. With one
dollar paid out for relief or public works or anything else, you have created four dollars’ worth of national
income.” 27 This describes the multiplier effect, an important tool of fiscal policy. [Fiscal policy means taxes or
spending.] Many Conservatives reject it, believing the multiplier is zero because government spending displaces
other spending. 28
The New Deal in fact was not very ideological—its policies were a pragmatic response to crisis. Its most
important early economic policy was putting people directly to work, still a good idea. Harry Hopkins, a social
worker, was put in charge of the Civil Works Administration in the fall of 1933. Hopkins created four million jobs,
mainly in construction, in the few months before it was ended in March 1934. 29
A bold fiscal policy during the Depression faced problems: in 1929, federal spending was under 4 percent
of GDP. To absorb the unemployed, federal spending needed to replace investment, which had collapsed. From
16% of output in 1929, it plunged to 3% of a far smaller output by 1933. 30 The federal share would have had to
rise by a multiple. That was both politically and practically impossible. With federal spending, including transfers
like Social Security, now nearly 21% of output, 31 the government can far more easily manage the economy with
modest fiscal changes. 32 Full employment awaited the military spending of WW 2.
The lack of information also impeded action: concepts and measures of income that we use now were
formulated because of the Depression. Despite these shortcomings, the New Deal accomplished a great deal by
putting millions, including artists and writers, back to work. The structures that its workers created are with us
still. We can visit over a thousand in New York City alone, like Brooklyn College, the Central Park Zoo, or
LaGuardia Airport. 33
After his visit, Keynes noted “this so-called ‘Bolshevik’ administration has saved the capital financial
structure,” called the recovery historically outstanding, and concluded, “The whole difficulty that confronts this
 4

liberal Administration is a world problem: can liberalism and democracy last out,—that is the problem everywhere.
Most American business leaders lack imagination and have no apprehension of the problem facing their society, if
it is to survive.” 34
Who was this economist who created a theoretical revolution? [Slide3] Keynes came from privilege at its
best —loving, intelligent and attentive parents who were intellectually and politically engaged, as well as
financially comfortable. His mother, Florence, was a writer, a social reformer active in helping the poor and
unemployed, and a politician. She was the first woman on the Cambridge City Council. 35 His father, John Neville
Keynes, was a renowned economist in his day. Philosopher Bertrand Russell called the son one of the most
intelligent people he had ever known. "Every time I argued with Keynes, I felt that I took my life in my hands and
I seldom emerged without feeling something of a fool." Born in 1883, Keynes showed an early gift for
mathematics. His education included some home schooling, Eton, and Cambridge University, where he earned a
mathematics degree. An early book was A Treatise on Probability. Russell, who co-authored Principia
Mathematica, described it as "undoubtedly the most important work on probability that has appeared for a very
long time." 36 Keynes’s professional career began in 1906, with an appointment to the British civil service. It
quickly bored him. Returning to teach at Cambridge, he first worked on probability theory, and then became an
economics lecturer in a post funded by famed economist Alfred Marshall. 37 In subsequent years, he worked for the
British Treasury, and was its chief representative at the Versailles Conference in 1919 ending WWI. He wrote an
important work, The Economic Consequences of the Peace, criticizing reparations imposed on Germany. “Keynes
brought a glittering array of talents” 38 to his work, combining theoretical brilliance in economic analysis with
practical problem-solving. He described his best ideas as coming “from ‘messing about with figures and seeing
what they must mean.’” 39 His enormous self-confidence, intellect and passionate engagement in social affairs
made him a successful and sought after participant in both academia and government. His personality contained
contradictions: he is described as “by turns charming and insupportable, cutting and kind, snobbish and
unpresuming; the public person is profoundly serious, extraordinarily hard-working, crushingly intelligent.” 40
[Slide4] At the Bretton Woods Conference in 1944, he and Harry Dexter White, representing the US, were
architects of the postwar trading system. US dominance of the agreement partially thwarted the aims of more
stable economies and high employment. 41 Keynes “...was by every account...an enormously persuasive negotiator,
quite willing to settle for the attainable, however distant that might be from the ideal.” 42
Keynes was a member of the famed Bloomsbury group, which included Virginia Woolf, apparently was
bisexual as he had affairs with several of its members, 43 and married in 1925. [Slide5] His wife was Lydia
Lopokova, chosen by Diaghilev for the Ballets Russes. 44 She had danced with Nijinsky and Ashton, married a
bigamist in New York, and had affairs with Igor Stravisky, among others. Her dancing charmed audiences with its
delicacy and ebullience. [Slide6] As a British newspaper described the marriage, “With the exception of Arthur
Miller and Marilyn Monroe, there can have been no odder celebrity couple....” Their snobbish circle ridiculed
 5

them. Virginia Woolf wrote, “They say you can only talk to Maynard now in words of one syllable,” though she
later came to admire Lydia’s intelligence and artistry. [Slide7] Lytton Strachey described her as a “half-witted
canary.” 45 Nevertheless, it was clearly a successful love match. 46 E.M. Forster later regretted “how we all used to
underestimate her.” She was a supportive wife, and thought his major work “beautiful like Bach.” “Without her
constant attention and joie de vivre, Keynes might not have made it to Bretton Woods.” 47 Keynes died of a second
heart attack at age 62 in April 1946, shortly after returning from contentious loan negotiations in the US. He
predeceased both of his parents. 48
In economics, Keynes began as a monetarist, believing that the economy could be stabilized by varying
interest rates, a theory unfortunately with us still. However, when British unemployment reached levels as high as
20% in the interwar period, it was clear that monetarism was insufficient. His ideas changed dramatically. He
began advocating public works as early as the 1920’s. His work eventually revolutionized economic theory. It
changed the standard practice of budget balance in favor of deficit spending during economic downturns. Keynes,
at least, expected that they’d be offset with surpluses as inflation threatened. 49 He didn’t acknowledge the work of
predecessors with grace. He refers to earlier underconsumption theories as “liv[ing] on furtively, below the surface
in the underworlds of Karl Marx” and others.
Let’s look more closely at his major work, The General Theory. Economic theory is important, both in
explaining economic phenomena, and guiding measurement. According to Keynes, income is determined by
spending. This theory is the reason our income and output accounts are measured as they are. 50 During the
Depression, information about the state of the economy was scarce, so Congress asked the Dept. of Commerce to
come up with income measures. It issued the first series of output data and income data by industry and type of
income in 1934, updating the last complete income accounts from 1929. 51 Monthly data were not available until
1938. The first complete output data, including major expenditure categories, appeared in early1942, with a final
version basically in place by 1947. Government officials of the 1930’s had to cope without good or timely
information of what had gone wrong and to what extent programs were effective. Wartime mobilization was done
without good data.
Because income depends on spending, the question is, what determines spending? Total spending is the
sum of spending by each major economic group--households, government, the foreign sector, and businesses.
These categories are chosen because each has a different motivation. Consumer spending depends on many
variables, but our income is the most important. Income includes both earnings and transfer payments like
Social Security. Government spending depends not only on its income, but on politics. Foreign sector
spending, which is exports minus imports, depends on the value of the dollar, and tastes and income here and
abroad. Business spending---investment---depends on expectations of profit from adding capacity, not on profits
from existing plant.
 6

Those words--expectations and adding capacity—are significant: they account for the variability of
investment. "Expectations" means that the climate of opinion influences business decisions. Their outcome is
uncertain because the future is unpredictable. This psychological base implies that decisions can change rapidly.
"Profits from adding capacity" means that firms must have a reason to add plant or equipment. Profit on current
sales, however great, won’t induce firms to expand output. This will only happen if they expect that the output
from building more plants or buying new machinery can be profitably sold. So high current profits don't
necessarily mean that firms will make new investments. [A busy, profitable store that served local people in my
modest neighborhood doubled its size and aimed at a higher-income clientele. Within a few months it was gone. It
had doubled costs without increasing customers. The owners had been misled by current profits. ] Summing up,
the motivation for firms to invest requires that something has changed. If sales are not higher than existing plant
can produce, if no new equipment is available that will pay for itself by reducing costs, if a new product is not
available, or if their expectations about the future are no brighter, there is no reason to invest. 52
In Keynesian theory, what equates saving to investment is not the interest rate, as in Classical theory, but
income changes. Neither investment nor saving depends primarily on the interest rate. If consumers save more than
businesses want to invest, then output will fall, reducing household incomes until their saving does match
investment. Investment determines saving rather than the reverse. Though saving is individually rational, it can
cause recession. If households try to save more, and this saving is not offset by spending elsewhere, output will
decline and saving will fall. 53 This is the reason some have said that consumers are the real job-creators. You can
also see how important research and development are to continued high investment. Government is one supporter
of R and D. Transistors, jet engines, computers, 54 the internet--all these were developed through military funding,
and all have inspired important new investments by private firms and new goods to tempt consumers. Keynes
believed that as economies became richer and households saved a larger fraction of income, the chronic problem of
insufficient investment for full employment would become worse. 55 Thus the need for a larger role for public
investment.
What made the acceptance of Keynesian policy and the relatively egalitarian growth of the postwar period
possible? Several things: first, the Depression delegitimized capitalism and its economic model. Keynesian theory
explained why that model had failed, and provided an alternative. The 1937 slump, which resulted from a return to
“sound finance,” provided a test, dramatically illustrating that cutting spending and increasing taxes could make
unemployment worse. 56
WWII was also a test: the economy flourished, supporting both the war and [Slide8] the highest
consumption ever achieved. Note the black bar measuring consumption rises to the 1929 level by 1941, then
continues to exceed it right through the war. And it’s understated because soldiers’ consumption is included in
government spending. [Slide9] All despite debt [blue line] now considered ruinous--up to 120% of output.
Postwar, the unparalleled global competitiveness of US companies made them willing for a time to share rising
 7

output per worker with a militant labor force. The threat of unionization and the expectation of a rising standard of
living extended benefits gained by unions to a wider labor force. Our succeeding history suggests that this era was
an aberration.
Many analysts worried about a postwar recession and return to high unemployment. Our government had
adopted Keynes’s idea of compulsory saving, that is, war bonds and taxation, not only deficit spending, to finance
the war. This good advice helped to stem both inflation and a postwar slump. 57 Transition to a postwar economy
was fairly smooth, thanks to war bonds and pent-up demand for consumer goods, but problems were visible early.
[Slide10] Despite the Marshall Plan and enormous recovery needs from the Depression and war shortages, the US
suffered a minor recession in 1949, with unemployment rising to 7% for part of the year. Wartime output reached
a historic maximum in 1944, not reached again until 1951, the first full year of the Korean War, 58 and a tripled
military budget.
Muting Conservative opposition to public spending meant finding projects which don’t compete with the
private sector. Public housing competes with private; publicly financed medicine competes with private insurers;
unemployment payments increase worker bargaining power. One answer was found in military spending, which,
far from competing, supports the private sector—providing markets, supporting R and D, and protecting foreign
markets and assets. 59 Keynes had described the utility of useless output to economic progress: “Just as wars have
been the only form of large-scale loan expenditure which statesmen have thought justifiable, so gold-mining is the
only pretext for digging holes in the ground which has recommended itself to bankers as sound finance.” 60
In 1949, the success of the Chinese revolution and Soviet test of an atomic bomb, large Communist parties
in Europe, rising anti-colonial movements in the Third World, and a challenging though weak Soviet Union [SU],
raised concerns about maintaining supremacy of the US economic model. Our chronic insufficiency of spending
was an important weakness shaping policy. Conservative economist Milton Friedman’s economic dictum was
"There is no free lunch." In contrast, a colleague, Soviet expert Lynn Turgeon, described the US and the SU,
respectively, as the Free Lunch Economy and the No Free Lunch Economy. By this he meant that the US usually
has sufficient unused production capacity and unemployed workers to increase output without more machines or
workers, i.e., the US could have a free lunch; the SU could not--it was always operating close to full capacity. This
difference meant that the real cost to the US of providing foreign aid and building a formidable military, the lost
alternative goods and services, was far less than for the SU. In fact, for the US this cost is usually not just zero, but
negative--that is, our standard of living improves as a consequence of higher spending. Our chronically underused
capital and labor means, for example, that filling a non-existent "missile gap" helped our economy, but meant a
sacrifice for the Russians. The US situation was obvious to some policy-makers. For example, Dean Acheson, at
that time Assistant Secretary of State, testified in 1944:
“You don't have a problem of production. The United States has unlimited creative energy. The important thing is markets.
...You must look to foreign markets.” 61
 8

Military Keynesianism, as it is called, has been one way of getting assent to government spending on machines and
research, thereby supporting economic growth. [Slide11] Military spending as a share of GDP reached a peak of
nearly 40% during World War 2, and postwar peak of 15% during the Korean War. The Soviets always were using
a larger fraction of their output for military, about 60% during WW 2. Our proposed military budget for next year,
including such items as veterans’ affairs and homeland security, is $1.1 Trillion, 62 about 6% of GDP. Though the
share has diminished, the military buys 10% of factory output. 63 The recent budget increase alone is enough to pay
tuition for every public university student in the country, with billions to spare. 64
Conceptually, the policy began with NSC 68, in 1950, 65 a secret document of the National Security
Council declassified in 1975. Its argument was that military spending would harm Soviet growth while enhancing
ours.
... in contrast to ours, [the capabilities of the Soviet world] are being drawn upon close to the maximum possible extent. .…. No
matter what efforts Moscow might make, only a relatively slight change in the rate of increase in overall production could be
brought about. 66

Its economic thesis, that military spending would be good for the US economy and bad for the Soviets, helped to
shape Cold War strategy. 67
Though Keynesian theory has been controversial for much of its history, for a time even Richard Nixon
proclaimed, “We are all Keynesians now.” The theory was accepted not only because of its success, but because
the most controversial parts were ignored or misinterpreted. Those that undercut support for inequality and policies
that implied long-term problems, like the socialization of investment, were dropped.
Keynes believed any return above cost of production, called economic rent, was unwarranted. Here he is in
the Classical tradition. Smith and Ricardo despised rent-receivers, like landlords whose rents rose only because
larger populations forced the use of less fertile land. Keynes considered capital artificially scarce, and proposed
eliminating both its scarcity and the return based on it. This would leave returns to skill, risk and entrepreneurship,
all productive. Keynes advocated driving the interest rate to zero. 68 His theory removed a major buttress for
inequality—saving, rather than necessary, impedes capital formation. He said, “One of the chief social
justifications of great inequality...is, therefore, removed.” 69
In our day, rents proliferate, like high prices for coops near the Met Breuer, 70 or corporate managers using
profits to buy company stock to drive up its price rather than investing. Rentier activities like oil, real estate and
minerals get tax privileges. 71 Returns exceeding the growth rate promote inequality. 72 A Harvard Business Review
article reports that rents have risen at the expense of both the wage and capital share. 73 In the opinion of Nobelist
Angus Deaton, “rent-seekers like the banking and the health-care sectors just might [kill capitalism].” Rent-
seeking slows growth: “All that talent is devoted to stealing things, instead of making things,” he says. 74
Also damaging to the theory were reinterpretations, like the early and successful attempt to make
the General Theory compatible with classical theory, called the neoclassical synthesis. 75 This combined watered-
down Keynesian macroeconomics with classical micro, like wage setting. Most notable in this effort was Paul
 9

Samuelson, first economics Nobelist and author of a highly popular textbook, published in1948. 76 Joan Robinson,
a distinguished economist and colleague of Keynes, called this school “Bastard Keynesians,” 77 many now called
New Keynesians. 78 Some, like Paul Krugman, claim the problem of recession is sticky wages: “...shortfalls in
overall demand would cure themselves if only wages and prices fell rapidly in the face of unemployment. In
reality prices don’t fall quickly....” 79 This contradicts Keynes—he pointed out that falling wages would make
matters worse by reducing consumer spending. Further, the successful expansion of the postwar era led
economists to treat the theory as merely a short-term remedy for business cycles. A British Labour official
described this “Keynesian consensus” as “thinking...of our economic difficulties as arising from... market failures,
irrationalities,... inflexibilities, ... and the like—as events that are somehow abnormal.... This ...is profoundly
misleading. ....The whole history of capitalist society reveals nothing if not the unwelcome normalcy of such
events.” 80 Editors of a Marxist journal add,
"This sanitized version ... dropped much of the concern with inequality and social spending....Bastard
Keynesians proclaimed that, with smart government policies, the system would work beautifully. The stagflation
of the 1970s demolished this belief and left establishment Keynesianism largely discredited. ...it increasingly was
framed as the cause of capitalism’s growth problems, not the cure.” 81

Keynesian theory proved inadequate to the counterattack for other reasons. Michal Kalecki pointed out the
political problem in 1943. 82
The assumption that a government will maintain full employment in a capitalist economy if it knows how to do it is fallacious.
[With] permanent full employment, ‘the sack’ would cease to play its role as a disciplinary measure.... The workers would get
out of hand and the captains of industry would be anxious ‘to teach them a lesson.’ ...big business and rentier interests... would
probably find more than one economist to declare that the situation was manifestly unsound. 83

Economic genius requires deep understanding of the structure and dynamics of a system constantly
changing. This is hard: the originator of Quantum Theory told Keynes that “he had thought of studying
economics, but had found it too difficult.” 84 It is easier to be a great physicist than a great economist. Economic
analysis, however brilliant, is historically-bound, and eventually undermined by changes that contradict its
assumptions. Adam Smith’s prescient description of an emerging market system is now irrelevant. In his time,
government-granted monopolies like the East India Company were the only source of market control. Excluding
them would not produce a completely level playing field, but would be close enough to self-regulating markets.
New producers could enter an industry and undermine a monopoly firm’s market power. Governments still grant
monopolies through patents, but there are other sources of market power, like technology, political influence or
sheer size. A company like Goldman Sachs can use these to influence its markets.
Keynes’s theory is also time-bound. Globalization and finance have changed the way policy works. Both
undermine the effectiveness of fiscal policy. Rising incomes fund more imports, for example, undercutting
government stimulus. The financial sector’s revenues may be used for unproductive investment, like the leveraged
buyout 85 of the now bankrupted Toys R US. The unleashed financial sector gave us three crises in the last thirty
 10

years 86 and is far more powerful than in the 1930’s, when New Dealers could regulate it. Not now. Despite the
worst crisis since the Depression in 2008, the system is still at risk. 87
Some theorists have updated Keynes’s work on finance. [Slide12] According to Hyman Minsky’s
financial-instability hypothesis, a long period of stability, like the postwar, obscures the potential for instability. In
fact, it creates conditions for the next crisis by inducing businesses to take on more risk, risk that can only be
justified by extravagant hopes. Expansion generates optimism and talk about the “death of the business cycle.” In
the 1990s, the “new economy” was supposed to have killed the business cycle by cementing faster productivity
growth. The dot.com bubble collapsed in 2000. In the 2000s, better monetary policy was credited with taming the
business cycle. Ben Bernanke, at that time on the Fed Board, called the low-wages, low inflation regime of Federal
Reserve Chair Alan Greenspan “the Great Moderation. 88 This is the Minsky cycle at work. Businesses became
more confident about the future and exercised less caution in taking out loans. 89 That bubble collapsed in late
2007.
Moreover, optimism infects all economic actors—regulators, businesses, banks, and home-buyers.
Economists, intoxicated by years of stability, supposed that they were permanent. Here is the 2003 assessment of
then president of the American Economic Association, Robert Lucas, a long-time anti-Keynesian:
[the] central problem of depression prevention has been solved, for all practical purposes....There remain important gains... from
better fiscal policies, but ... these are gains from providing people with better incentives to work and to save, not from better fine-
tuning of spending flows. 90

Minsky’s policies to prevent depression include government as employer of last resort to maintain both jobs and
profits; and the Federal Reserve regulating financial institutions by anticipating changes that might affect stability
rather than waiting to respond to disaster. 91
The most important attack on Keynes and the welfare state was neoliberalism. 92 Inspired by 19th century
laissez-faire, neoliberals advocate privatization, deregulation, free trade, and limited government, especially social
93
welfare spending. In Margaret Thatcher’s aphorism, “there is no society, only individuals.” A German
sociologist describes it as “a demobilization ...of the entire post-war machinery of democratic participation and
redistribution.” 94
What gave us this new economic regime? The corporate counterattack and shift in economic philosophy
began in 1971 with a memo by the soon to be Supreme Court justice Lewis Powell, and with the collapse of
Bretton Woods, beginning then. 95 The memo urged businesses to seek power and use it “aggressively.” 96 This was
a reaction to the progressive changes of the sixties. Post-Bretton Woods, international currency values changed
from fixed to fluctuating rates. Volatility of foreign-exchange rates created profit opportunities for Wall Street. 97
A phenomenal shift in policy began between 1978 and 1980. 98 In 1978, China began liberalizing its
command economy; Thatcher became British Prime Minister and Paul Volcker 99 became head of the Federal
Reserve in 1979; and Reagan became President in 1980. Their policies curbed labor power, deregulated the
economy and accelerated financial deregulation. 100 The Clinton Administration freed finance from New Deal
 11

restraints in the 1990’s, inspired by his Treasury Secretary, Robert Rubin, who then went on to Citigroup.
International capital flows increased, growth slowed, private and public debt rose, and financial crises occurred
more frequently. 101 The corporate world’s goal became maximizing shareholder value, mostly ignoring the welfare
of workers and communities. These may be connected to the corporation longer than shareholders.
The Soviet collapse in 1989 permitted an era of American triumphalism. Reagan, Bush and the Democrats
who followed them dismantled major regulations of the New Deal, weakened unions and welfare programs, and
negotiated trade agreements that encouraged outsourcing. 102 Neoliberals believed that their policies would ensure
stability and steady growth, and should be a model for all countries. Thatcher called it TINA--there is no
alternative. Lending institutions like the World Bank force it on debtor countries. 103
When the most dangerous crisis since the 1930’s came in 2008, it met a tepid fiscal response, accompanied
by a bailout of financial miscreants. Even that response was criticized by anti-Keynesians, including Nobel
Laureates. 104 In early 2010, despite an unemployment rate of 9.7%, President Obama created, over Senate
objection, the National Commission on Fiscal Responsibility and Reform with two deficit hawks as co-chairs. 105 It
was charged with creating a “grand bargain”—a compromise agreement to reduce the debt by cutting Social
Security, Medicare and military spending, and increasing taxes. 106 Fortunately, the compromise failed, succumbing
to Republican intransigence. [Slide13] Financial Times commentator Martin Wolf ridiculed the debt-mongers with
this graph, showing British debt at 250% of income during the industrial revolution. 107
The Administration went into the midterm election with unemployment higher than when it began, and a
stimulus far smaller than many experts thought sufficient. Larry Summers, who was responsible for keeping it
modest, now says, “I think in the end we would've been better served if there had been more push to the
economy.” 108 The current recovery is the slowest of the postwar era. It took eight years for unemployment to
recover its prerecession level. 109 [SLIDE14] Compare Reagan’s ample government spending [red line] with
Obama’s [blue line]. Private sector weakness was reinforced as federal jobs were cut every year from 2011 through
2013, and inflation-adjusted Federal spending on goods and services declined every year from 2011 through
2014. 110 Is it surprising that Democrats became the minority party around the country? 111 The Congressional
Budget Office estimates our potential output in 2017 at 10% below the level it had projected in 2008, before the
worst of the recession—a loss of roughly $2 trillion a year, or $6000 per person, imposed by the austerity agenda.
Economist Dean Baker points out that, for future generations, this is like a yearly tax increase. 112
What then about the debt created by anti-recessionary policy that is so worrisome to conservatives? 113
Keynes considered deficits acceptable as a means of offsetting deficiencies in private spending. However, unlike
his critics, he did not expect that his policies would generate massive, continuing deficits and inflation. His perhaps
too blithe comment was, “look after the unemployment, and the Budget will look after itself.” 114 [Slide15] Keynesian
Abba Lerner believed that, during major recessions, there is no inflationary pressure. Then, he recommended,
 12

deficits should be financed not by debt, but by Federal Reserve credit creation, in the vernacular, printing
money. 115
Keynes thought Lerner’s policy impractical, 116 as he considered the investment problem to be long-term for
rich countries with high savings and limited investment opportunities. He therefore expected a permanent role for
public investment, up to 20% of output, referring to “the socialization of investment.” 117 Given the volatility of
private investment, this would have a major stabilizing role. 118 Further, government spending sufficient to ensure
full employment would eliminate large budget deficits. In Keynes’s view, deficits result from the failure to reach
full employment. Deficits would occur only during minor recessions. 119 While public investment should be at least
partly debt-financed, the ordinary budget would usually be in surplus.
Since the 1990’s, there has been a counterattack against austerity. [Slide16] Modern Monetary Theory
extends Lerner, and provides an alternative to private credit creation. This theory asserts that the only reason to tax
is to control the level of spending. Greenspan would agree. Asked about the solvency of Social Security, he
replied, "There's nothing to prevent the federal government from creating as much money as it wants and paying it
to someone." 120 He added that the real question is whether goods are there for beneficiaries to buy. This implies
that government can minimize deficits by creating money to pay for its programs. 121 This would let us avoid the
austerity imposed by those claiming “there is no money,” though money is there for tax cuts, bailouts, or military
adventures. Currently, the important question of how much money we need is mostly decided by private banks, not
public officials. It is little understood that bank profits come mostly from creating money.
The Bank of England explains: 122

One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. ....In
123
reality, commercial banks are the creators of deposit money …. the act of lending creates deposits.
In 2017, a large US bank could extend $9 in loans, that is, create money, for every dollar in deposits. 124
Pavlina Tcherneva and some others of this school argue that Keynesian theory is also misinterpreted as
proposing solely to increase aggregate demand generally, raising the likelihood of inflation. 125 Rather, Keynes
preferred directed spending, like public works, to create employment, both during recessions and for
unemployment that continues even when an economy is near full employment. Remember that his target for
unemployment was less than 1%. 126 Keynes thought it ‘‘easy to employ 80 to 90 percent of the national
resources...” but “To employ [the rest], including labor, we would be ‘more in need . . . of a rightly distributed
demand than of greater aggregate demand.’” 127 Because “full, or even approximately full, employment is a rare
and short-lived occurrence,” 128 policy should aim to stabilize investment, not consumption, by public works. If
true, this is of enormous importance, as it would avoid the inflation that occurs if the policy is limited to increasing
aggregate spending. 129 Public works can be directed to geographic areas of need and specifically to unused
resources.
 13

How well have the promises of neoliberalism been kept? US median annual earnings during the Bretton
Woods era rose steadily until 1972. [Slide17] Then throughout the neoliberal era, real wages for men [blue line]
have stagnated. Now women’s [purple line] are stagnating, too. Catching up with productivity increases [green
dashes] is better for women than catching up with men. It would raise women’s wages by 70%. [Slide18] Global
growth rates have slowed as debt burdens soared, and the investment share declined. 130 [Slide19] Consumer debt
[red line], which rivals business and government debt, is worrisome, as households have neither the government’s
power to increase revenues nor to create money. [Slide-20] Student loan debt is over one-third of non-housing
debt. A German sociologist attributes to these failures the birth of “a new sort of political deceit...the expert lie. It
began with the Laffer Curve.” This predicted that lower tax rates would raise revenues, justifying the Reagan tax
cuts. 131
Then has neoliberalism failed? No. Its global reach continues, as corporations gain access to markets and
cheap labor through trade agreements that restrict government action. Governments continue to appoint Goldman
Sachs alumni to jobs, both here and abroad. Obama had several 132 and so does Trump, including Secretary of the
Treasury, chair of the SEC, and chief economic adviser. 133 Our rules continue to leave much of the social surplus
in the hands of a few. Globalizers tout the benefits without trying to offset their uneven distribution or even noting
them. [Slide21] Alan Greenspan, former Federal Reserve Chair, 134 acknowledged during hearings on the financial
crisis
“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity... are in a state of shocked
disbelief.”.... [to the question] Do you feel that your ideology pushed you to make decisions that you wish you had not
made?” Greenspan answered: “Yes, I’ve found a flaw.” 135

A form of privatized Keynesianism helped create the bubble that burst in 2008: households with lagging income
were induced to use debt to buy houses and maintain spending. 136
Anatole Kaletsky, writing for the Financial Times, describes our current plight. Capitalism, when it is
successful, provides material progress that mutes political pressure. It ceases to be acceptable when, in Keynes’s
phrase, “it doesn’t deliver the goods.” 137 It didn’t during the Depression and it doesn’t now.

1
www.federalobserver.com/wp-content/uploads/2009/03/the-once-and-future-money-bob-landis.pdf and
http://www.goldensextant.com/LLCPostings4.html#anchor237271
2
Lynn Turgeon, Bastard Keynesianism, p.1. Our data from https://fred.stlouisfed.org/series/M0892AUSM156SNBR
3
http://www.primeeconomics.org/articles/is-globalisation-dead
4
The Liberals created the beginnings of the British welfare state. https://en.wikipedia.org/wiki/Liberal_Party_(UK)
5
“Keynes and Beatrice Webb now embarked on an improbable friendship based on mutual fascination, much incomprehension, but
a shared belief in social science and public service.” http://www.skidelskyr.com/site/article/doing-good-and-being-good/
6
http://www.nybooks.com.ezproxy.hofstra.edu/articles/1967/01/26/smoothing-out-keynes/
7
Robert Skidelsky, Keynes: The Return of the Master,75. From Economic Possibilities for Our Grandchildren
8
http://www.skidelskyr.com/site/article/keynes-in-the-long-run/
9
Keynes, General Theory of Employment, Interest and Money, ch. 24, pp.378-9. He continued, “ I see no reason to suppose that the
existing system seriously misemploys the factors of production which are in use.”
10
He is said to have replied to a critic, “When I find new information I change my mind; What do you do?”
http://quoteinvestigator.com/2011/07/22/keynes-change-mind/
11
Tcherneva, Keynes’s Approach to Full Employment: Aggregate or Targeted Demand? Levy, Working Paper No. 542, 8/08, p.6.
 14

12
Tcherneva, “Permanent On-The-Spot Job Creation—The Missing Keynes Plan for Full Employment and Economic Transformation,”
Review of Social Economy, 70 (1) 66 http://dx.doi.org/10.1080/00346764.2011.577348, 65-6. Keynes, Collected Wks, v.27, 303.
13
www.levy.org/pubs/wp_542.pdf
14
Keynes, General Theory, Concluding Notes, p. 379.
15
Keynes, General Theory, p. 378. By 1943, Keynes thought that eventually, reduced work time would be a better solution than private
investment. “...the full employment policy by means of investment is only one particular application of an intellectual theorem. You can
produce the result just as well by consuming more or working less. Personally I regard the investment policy as first aid. In U.S. it almost
certainly will not do the trick. Less work is the ultimate solution (a 35 hour week in U.S. would do the trick now).” Quote from a letter to
TS Eliot, and Keynes, 1943: “The Long-Term Problem of full employment,” https://ecologicalheadstand.blogspot.com/p/long-term-
problem-of-full-employment.html
16
Robert Skidelsky, Keynes: The Return of the Master, 80
17
“Rick Perry showed up at a coal plant this week and invoked a novel economic theory to explain his push to expand coal mining in an
age of declining coal use. ‘Here’s a little economics lesson: supply and demand. You put the supply out there and the demand will
follow.’” https://www.counterpunch.org/2017/07/07/93955/
18
Quoted by Arthur Schlesinger, Crisis of the Old Order, p. 61.
19
http://review.chicagobooth.edu/magazine/summer-2013/simon-kuznets
20
To that date. www.ebhsoc.org/journal/index.php/journal/article/download/205/207
21
https://www.nytimes.com/2017/04/13/technology/artificial-intelligence-automation-report.html
22
“They [Keynes and Roosevelt] met in 1934, but most observers believed that Keynes had little impact on the president’s thinking.
Although Keynes’s ideas were in circulation by 1933, the lag between academic advances and their use in policy tends to take decades.....
Several of Roosevelt’s advisers also argued for using government programs as a stimulus, but they followed a different logical path for
their arguments.” https://www.cfr.org/content/thinktank/Depression/Fishback_NewDeal_Chapter.pdf
23
https://en.wikipedia.org/wiki/John_Maynard_Keynes
24
Means to Prosperity http://crookedtimber.org/2013/06/17/the-queer-personality-and-floating-mind-what-did-keynes-say-to-and-about-
roosevelt-2/
25
NY Times, June 10, 1934.
26
http://crookedtimber.org/2013/06/17/the-queer-personality-and-floating-mind-what-did-keynes-say-to-and-about-roosevelt-2/
27
http://crookedtimber.org/2013/06/17/the-queer-personality-and-floating-mind-what-did-keynes-say-to-and-about-roosevelt-2/
28
Like Robert Lucas: “Rational-expectations economists supposed that fiscal policy would be undermined by forward-looking taxpayers.
They should understand that government borrowing would eventually need to be repaid, and that stimulus today would necessitate higher
taxes tomorrow. They should therefore save income earned as a result of stimulus in order to have it on hand for when the bill came due.
The multiplier on government spending might in fact be close to zero, as each extra dollar is almost entirely offset by increased private
saving.” http://www.economist.com/news/economics-brief/21704784-fiscal-stimulus-idea-championed-john-maynard-keynes-has-gone-
and-out
29
The CWA's workers laid 12 million feet of sewer pipe and built or improved 255,000 miles of roads, 40,000 schools,
3,700 playgrounds, and nearly 1,000 airports (not to mention building 250,000 outhouses still badly needed in rural America). The
program was praised by Alf Landon, who later ran against Roosevelt” in 1936. It was abandoned under criticism by conservatives, who
argued it produced little of value. WPA replaced it. https://en.wikipedia.org/wiki/Civil_Works_Administration
30
https://www.bea.gov/scb/pdf/2011/08%20August/0811_gdp_nipas.pdf GDP=103.6B and I=16.5B in 1929; 56.4B and 1.7B resp,
in 1933.
31
Interest is 1.4%. http://www.cbpp.org/research/federal-budget/program-spending-as-a-percent-of-gdp-historically-low-outside-social
32
In 2016, F=3.85tr; S/L=3.5 [almost =]; 34% 2015 including trs. 2016: SS=5%; medicare=3+%; welfare & Medicaid-6%
http://www.usgovernmentspending.com/welfare_spending_analysis Total f/s/l: 36% GDP in 2017
33
See the Living New Deal: https://livingnewdeal.org/map/
34
1934. http://crookedtimber.org/2013/06/17/the-queer-personality-and-floating-mind-what-did-keynes-say-to-and-about-roosevelt-2/
35
https://en.wikipedia.org/wiki/Florence_Ada_Keynes
36
https://en.wikipedia.org/wiki/A_Treatise_on_Probability
37
https://en.wikipedia.org/wiki/John_Maynard_Keynes
38
Robert Skidelsky, Keynes: Return of the Master, 76.
39
Skidelsky, ibid., 78.
40
https://www.theguardian.com/books/2015/mar/08/universal-man-seven-lives-john-maynard-keynes-review and
http://www.nytimes.com/books/98/12/06/specials/skidelsky-keynes.html
41
“... the point of the system that Keynes hoped to design was to prevent imbalances between nations — that is, one nation owing too much
to another, thus causing onerous debt repayments.... Keynes — along with the equally brilliant founder of Buddhist Economics..., EF
Schumacher — proposed something really radical, revolutionary, beautiful, transformative. History’s first ultranational currency, Bancor.
Bancor wasn’t a currency that you or I could hold: only governments could hold it, only gold could be exchanged for it, only the IMF could
lend and settle it, and... if you held too much, you’d be charged interest....It was the single most brilliant institutional design probably in
human history.....Because America was the stronger party in the post-war negotiations, Bancor never came to be. Why did America object
 15

to Bancor? Largely for selfish reasons: so the dollar could become the world’s reserve currency.” https://medium.com/bad-words/why-the-
world-is-better-off-without-american-leadership-40f774faf44a
42
Robert Lekachman, “The Radical Keynes,” in Harold Wattel, The Policy Consequences of John Maynard Keynes, 36-7.
43
https://en.wikipedia.org/wiki/John_Maynard_Keynes
44
The Keyneses later were backers of the Royal Ballet.
45
https://www.lrb.co.uk/v30/n24/alison-light/lady-talky
46
http://www.dailymail.co.uk/home/books/article-1017464/Beauty-Brain.html May 8, 2008.
47
https://www.lrb.co.uk/v30/n24/alison-light/lady-talky
48
https://en.wikipedia.org/wiki/John_Maynard_Keynes
49
The first government to adopt demand management policies was Sweden in the 1930s.
https://en.wikipedia.org/wiki/Keynesian_Revolution
50
http://www.economist.com/news/briefing/21697845-gross-domestic-product-gdp-increasingly-poor-measure-prosperity-it-not-even
51
The data discussion is based on Marcuss & Kane, “U.S. National Income and Product Statistics Born of the Great Depression and
World War II,” SCB, https://www.bea.gov/scb/pdf/2007/02%20February/0207_history_article.pdf Output data were measured from
industries like services, finance, manufacturing, and govt; income by wages and salaries in selected industries, dividends, rents, interest,
etc.
52
“These days, “pre-crash (2006), over 30 percent of the profits of American corporations classified as “industrial” came from financial
transactions rather than the production of goods and provision of services.” https://www.brookings.edu/wp-
content/uploads/2016/06/Whose-Capital-What-Gains.pdf
53
This is the paradox of thrift.
54
Transistors needed for missile guidance. Defense agencies, such as the Office of Naval Research, Army Research Office, Air Force
Office of Scientific Research, and Defense Advanced Research Projects Agency, invested in computing research with long-term effects
on military capabilities (and, indirectly, civilian capabilities). 1945 The ENIAC built at the University of Pennsylvania and funded by the
Army Ballistic Research Laboratory, was America's first such machine.
55
Keynes, “It is certain that the world will not much longer tolerate the unemployment which, apart from brief intervals of excitement, is
associated and in my opinion, inevitably associated with present-day capitalistic individualism.” General Theory, 381. See also
Skidelsky, “Keynes believed that, under laissez-faire, full employment levels of investment were achieved only in moments of excitement
strong enough to overcome the uncertainty normally attaching to estimates of future returns. The normal tendency was for the propensity
to save to be stronger than the inducement to invest. Moreover, this problem would grow more acute the richer societies became, because
people tended to save a higher fraction of higher incomes even as perceived (and actual) opportunities for profitable investment declined.”
Keynes: The Return of the Master, 198.
56
Joan Robinson, “Smoothing Out Keynes,” NYRB 1/26/67.
57
“... Keynes argued in How to Pay for the War...[1940], that the war effort should be largely financed by higher taxation and especially
by compulsory saving (essentially workers lending money to the government), rather than deficit spending, in order to avoid inflation.
Compulsory saving would act to dampen domestic demand, assist in channelling additional output towards the war efforts, would be
fairer than punitive taxation and would have the advantage of helping to avoid a post war slump by boosting demand once workers were
allowed to withdraw their savings.” https://en.wikipedia.org/wiki/John_Maynard_Keynes
58
began June, 1950
59
As Times columnist Thomas Friedman has told us, ‘The hidden hand of the market will never work without a hidden fist -- McDonald's
cannot flourish without McDonnell Douglas, the builder of the F-15. And the hidden fist that keeps the world safe for Silicon Valley's
technologies is called the United States Army, Air Force, Navy and Marine Corps.”
http://www.nytimes.com/books/99/04/25/reviews/friedman-mag.html
60
“Two pyramids, two masses for the dead, are twice as good as one; but not so two railways from London to York.” General Theory,
130-1.
61
James E. Cronin, The World the Cold War Made, p.22.
https://books.google.com/books/about/The_World_the_Cold_War_Made.html?id=YmhX0qYrA48C
62
http://www.pogo.org/straus/issues/defense-budget/2017/americas-1-1-trillion-national-security-budget.html GDP c $19tr 2017, ERP
63
https://www.nytimes.com/2017/09/22/business/economy/military-industrial-complex.html
64
Budgeted increase is about $80B. http://fair.org/home/outlets-that-scolded-sanders-over-deficits-uniformly-silent-on-700b-pentagon-
handout/
65
https://rwer.wordpress.com/2016/12/27/military-keynesianism-and-the-military-industrial-complex/
66
https://fas.org/irp/offdocs/nsc-hst/nsc-68-5.htm
67
“An extraordinary new Pentagon study [A t O u r O w n P e r i l : D o D R i s k A s s e s s m e n t i n a P o s t - P r i m a c y W o r l d ,
6/17, Nathan P. Freier, Col. (Ret.) Christopher M. Bado, Dr. Christopher J. Bolan, Col. (Ret.) Robert S. Hume, Col. J. Matthew Lissner.
https://ssi.armywarcollege.edu/pubs/display.cfm?pubID=1358 Statregic Studies Inst, US Army War College--my files]
has concluded that the US-backed framework of international order established after World War II is “fraying” and may even be
“collapsing,” leading the United States to lose its position of “primacy” in world affairs. The solution proposed to protect US power in
this new “post-primacy” environment is, however, more of the same: more surveillance, more propaganda (“strategic manipulation of
perceptions”) and more military expansionism.”
 16

68“euthanasia of the rentier” General Theory, 376. “...the amount of capital needed to operate an economy at full
employment is limited, and once achieved, the marginal return to capital will drop to the point that it merely covers
depreciation, obsolescence, and a small return for risk and for managerial skill and judgment. ‘Now, though this state of affairs
would be quite compatible with some measure of individualism, yet it would mean the euthanasia of the rentier, and, consequently, the
euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital.’”
https://shadowproof.com/2013/02/10/euthanasia-of-the-rentier/
69
General Theory, 373.
70
http://michael-hudson.com/2016/10/rentier-capitalism-veblen-in-the-21st-century/
71
Minerals, timber, oil and gas get a depletion allowance. Real estate gets depreciation, value appreciates.
72
Hudson interview, https://harpers.org/blog/2017/06/slow-crash/
73
https://www.bloomberg.com/view/articles/2017-06-21/the-wrong-kind-of-entrepreneurs-flourish-in-america based on
https://hbr.org/2017/06/is-america-encouraging-the-wrong-kind-of-entrepreneurship
74
“Nobel economist takes aim at rent-seeking banking and healthcare industries,” http://www.marketwatch.com/story/nobel-economist-takes-aim-at-
rent-seeking-banking-and-healthcare-industries-2017-03-06
75
https://en.wikipedia.org/wiki/Keynesian_Revolution
76
“To complete the reconciliation of Keynesian economics with general equilibrium theory, Paul Samuelson introduced the neoclassical
synthesis in 1955. According to this theory, if unemployment is too high, the money wage will fall as workers compete with each other
for existing jobs. Falling wages will be passed through to falling prices as firms compete with each other to sell the goods they produce. In
this view of the world, high unemployment is a temporary phenomenon caused by the slow adjustment of money wages and money
prices. In Samuelson’s vision, the economy is Keynesian in the short run, when some wages and prices are sticky. It is classical in the
long run when all wages and prices have had time to adjust.” http://evonomics.com/new-keynesian-economics-betrays-keynes/
77
Lynn Turgeon, Bastard Keynesianism, p. 113.
78
https://larspsyll.wordpress.com/2013/06/05/paul-krugman-a-bastard-keynesian/
79
Krugman, The Return of Depression Economics and the Crisis of 2008, pp 182-3. Quoted in John Eatwell & Murray Milgate, The Fall
and Rise of Keynesian Economics, 13. In any case, wages did decline during the Depression.
80
Eatwell and Milgate, op. cit., p. 16. Eatwell is a noted British Keynesian.
81
https://monthlyreview.org/2010/04/01/listen-keynesians-its-the-system-response-to-palley/
82
http://delong.typepad.com/kalecki43.pdf
83
Kalecki, Political Aspects of Full Employment, https://mronline.org/2010/05/22/political-aspects-of-full-employment/
https://www.socialeurope.eu/a-macroneconomic-revolution
84
Max Planck, quoted by Keynes in Alfred Marshall’s obit: Economic Journal, V. 34, N. 135 (Sep., 1924), p. 333, fn 2. http://semillero-
hpe.wikispaces.com/file/view/Keynes24+-+Alfred+Marshall.pdf
85
https://www.nakedcapitalism.com/2017/09/toys-r-us-another-private-equity-casualty.html
86
A banking crisis in the early 1980’s https://en.wikipedia.org/wiki/Early_1980s_recession#Financial_industry_crisis the dot.com in the
late 1990’s and the 2008 financial crisis.
87
https://www.bloomberg.com/view/articles/2017-08-10/there-s-still-too-much-risk-in-the-financial-system
andhttps://www.theguardian.com/commentisfree/2017/sep/14/the-financial-system-is-still-blinking-red
88
in 2004. https://monthlyreview.org/2010/04/01/the-limits-of-minskys-financial-instability-hypothesis-as-an-explanation-of-the-crisis/
and https://newleftreview.org/II/97/adam-tooze-just-another-panic
89
Minsky distinguished between three kinds of financing. ...“hedge financing”, is the safest: firms rely on their future cashflow to repay
all their borrowings. For this to work, they need to have very limited borrowings and healthy profits. The second, speculative financing, is
a bit riskier: firms rely on their cashflow to repay the interest on their borrowings but must roll over their debt to repay the principal. This
should be manageable as long as the economy functions smoothly, but a downturn could cause distress. The third, Ponzi financing, is the
most dangerous. Cashflow covers neither principal nor interest; firms are betting only that the underlying asset will appreciate by enough
to cover their liabilities. If that fails to happen, they will be left exposed..... When speculative and, especially, Ponzi financing come to the
fore, financial systems are more vulnerable. If asset values start to fall, either because of monetary tightening or some external shock, the
most overstretched firms will be forced to sell their positions. This further undermines asset values, causing pain for even more firms.
They could avoid this trouble by restricting themselves to hedge financing. But over time, particularly when the economy is in fine fettle,
the temptation to take on debt is irresistible. When growth looks assured, why not borrow more? Banks add to the dynamic, lowering their
credit standards the longer booms last. If defaults are minimal, why not lend more? Minsky’s conclusion was unsettling. Economic
stability breeds instability. Periods of prosperity give way to financial fragility.” http://www.economist.com/news/economics-
brief/21702740-second-article-our-series-seminal-economic-ideas-looks-hyman-minskys
90
Robert Lucas, “Macroeconomic Priorities,” AER 3/2003, cited by John Eatwell & Murray Milgate, The Fall and Rise of Keynesian
Economics, p.2.
91
“Just as there never really was a Keynesian revolution in economic theory, there also never really was one in policy. […] All that was
assimilated from Keynes by the policy establishment and its clients was the analysis of an economy in deep depression and a policy tool
of deficit financing. […]The institutional structure has not been adapted to reflect the knowledge that the collapse of aggregate demand
and profits, such as occasionally occurred and often threatened to occur in pre-1933 small government capitalism, is never a clear and
present danger in Big Government capitalism such as has ruled since World War II. (Minsky 1986: 291, 295)” Eric Tymoigne, Minsky
 17

and Economic Policy: “Keynesianism” All Over Again? , Levy WP #547, p.22. Government should act as both employer and lender of
last resort. Minsky, “Financial Instability and the Decline (?) of Banking: Public Policy Implications,” Hyman P. Minsky Archive. Paper
88. http://digitalcommons.bard.edu/hm_archive/88 p. 9. Minsky also recommended eliminating corporate income taxes as they encourage
debt finance, which is destabilizing. Stabilizing an Unstable Economy, 354.
92
https://monthlyreview.org/2017/04/01/who-is-behind-the-assault-on-public-schools/
93
https://en.wikipedia.org/wiki/Neoliberalism
94
NLR104, March-April 2017
95
For instance, from about the 1930s to the 1980s, many countries had policies of financial regulation that included many of the
following: 1. Interest rate ceilings 2. Liquidity ratio requirements 3. Higher bank reserve requirements 4. Capital Controls (that is,
restrictions on capital account transactions) 5. Restrictions on market entry into the financial sector 6. Credit ceilings or restrictions on the
directions of credit allocation 7. Separation of commercial from investment (“speculative”) banks 8. Government ownership or
domination of the banks. (Ito 2009: 431–433). https://socialdemocracy21stcentury.blogspot.com/2009/11/financial-deregulation-and-
origin-of.html
96
http://billmoyers.com/content/the-powell-memo-a-call-to-arms-for-corporations/
97
Gowan, “Crisis in the Heartland, “ New Left Review 55 jan feb 2009. “...as recently as 1975 roughly 80% of foreign exchange
transactions involved the real trading of a product or a service. The remaining 20% were speculative.... By the late 90s that ratio had
changed dramatically. In 1997 the percentage of foreign exchange which involved transactions in the real economy was only 2.5%.
Today, the picture is even starker. According to the Global Policy Forum, in 2011 only 0.6% of foreign exchange could be traced to
genuine international trade in goods and services. Of the rest, a minimum of 80% was directly attributable to exchange rate speculation.....
An estimated $5.3tn changes hands every day in the foreign exchange markets. That is an entire year's worth of the European Union's
GDP, gambled every three days.” https://www.theguardian.com/commentisfree/2013/nov/20/money-trading-economy-foreign-exchange-
markets-economy
98
http://bilbo.economicoutlook.net/blog/?p=37018 Alan Blinder commented ...that by: “… about 1980, it was hard to find an American
macroeconomist under the age of 40 who professed to be a Keynesian. That was an astonishing turnabout in less than a decade, an
intellectual revolution for sure.”
99
“The standard of living of the average American has to decline." http://www.nytimes.com/1979/10/18/archives/volcker-asserts-us-
must-trim-living-standard-warns-of-inflation.html
100
David Harvey, A Brief History of Neoliberalism, op. cit., 1
101
“The average annual increase in world GDP...was higher in the period 1952-75 than in the period since 1975, although that expansion
in economic activity was somewhat faster in the advanced economies. ....Advocates of globalisation as well as their opponents continue to
draw attention to flows of trade and labour, thereby deflecting attention from that which is most causal of instability and insecurity:
financialisation of the global economy – when banks and the finance sector dominate and distort the real economy.... This is done by
withholding affordable finance from the real economy, engaging in speculation and risk, making money from money rather than from
investment in productive sustainable activity that creates jobs, wages and profits.” Pettifor https://urpe.wordpress.com/2017/05/26/the-
neoliberal-road-to-autocracy/ original http://www.ips-journal.eu/opinion/article/show/the-neoliberal-road-to-autocracy-2046/Germany’s
disastrous Eurozone policy illustrates “pre-Keynesian ideas that most macroeconomists rejected many years ago.”
https://www.socialeurope.eu/2017/05/rethinking-german-economic-policy/
102
The Liberal Order is Rigged: “The fall of the Soviet Union removed the main “other” from the American political imagination and
thereby reduced social cohesion in the United States. The end of the Cold War generated particular political difficulties for the Republican
Party, which had long been a bastion of anticommunism. With the Soviets gone, Washington elites gradually replaced Communists as the
Republicans’ bogeymen. Trumpism is the logical extension of that development. ....During the Cold War, leaders in Western Europe
constantly sought to stave off the domestic appeal of communism and socialism. After 1989, no longer facing that constraint, national
governments and officials in Brussels expanded the EU’s authority and scope, even in the face of a series of national referendums that
expressed opposition to that trend and should have served as warning signs of growing working-class discontent..... Without the specter of
communist-style authoritarianism haunting their societies, eastern Europeans have become more susceptible to populism and other forms
of illiberalism. In Europe, as in the United States, the disappearance of the Soviets undermined social cohesion and a common sense of
purpose.” https://www.foreignaffairs.com/articles/world/2017-04-17/liberal-order-rigged
103
https://www.lrb.co.uk/v31/n22/john-gray/we-simply-do-not-know
104
Some economists resisted even this. “There are a number of economists who strongly object to even the basic idea that government
spending is a useful tool during this crisis. For example, 1995 Nobel Laureate Robert Lucas called multiplier estimates from
Economy.com “schlock economics”; John Cochrane of the University of Chicago has called government spending stimulus “a fallacy”;
Robert Barro of Harvard called one version of the American Recovery and Reinvestment Act (ARRA) “the worst bill that has been put
forward since the 1930s.”Other economists say stimulus proponents are basing their arguments on the economics of yesteryear. Thomas
Sargent of New York University and the Hoover Institution remarked that the support for the ARRA “ignore[s] what we have learned in
the last 60 years of macroeconomic research,” while 2004 Nobel Laureate Edward Prescott has said, “Stimulus is not part of the language
of economics. There is an old, discarded theory that’s been tried and failed spectacularly. The stimulus bill is likely to depress the
economy.” https://www.forbes.com/2009/06/16/stimulus-arra-government-spending-krugman-prescott-opinions-contributors-
ohanian.html
105
Erskine Bowles and Alan Simpson, https://en.wikipedia.org/wiki/National_Commission_on_Fiscal_Responsibility_and_Reform
 18

https://obamawhitehouse.archives.gov/blog/2010/02/18/welcoming-national-commission-fiscal-responsibility-and-reform The flawed

Reinhardt-Rogoff study http://www.nber.org/papers/w15639 appeared in 1/2010 appeared 1/2010.
106
http://www.huffingtonpost.com/entry/barack-obama-grand-bargain-social-security-expansion_us_5751f92de4b0eb20fa0e0142
107
http://www.ft.com/intl/cms/s/0/60b7a4ec-ab58-11e2-8c63-00144feabdc0.html#axzz2RiOKjy22 "Between 1815 and 1855…debt
interest accounted for close to half of all …public spending. … By the early 1860s, debt had… fallen below 90 per cent of GDP."
108
http://www.economist.com/blogs/freeexchange/2011/07/stimulus
109
BLS data set https://data.bls.gov/pdq/SurveyOutputServlet
110
https://www.bea.gov/iTable/iTable.cfm?reqid=9&step=3&isuri=1&903=1#reqid=9&step=3&isuri=1&904=2008&903=1&906=a&905
=2017&910=x&911=0 Economic Report of the President, Table B-1, 565. https://www.gpo.gov/fdsys/pkg/ERP-2017/pdf/ERP-2017-
table19.pdf Total Federal spending, including transfers, also declined 2012 and 2013 in current $.
111
https://en.wikipedia.org/wiki/United_States_elections,_2010
112
$81B increase vs 70 B for tuition http://fair.org/home/deficit-scare-tactics-are-what-citizens-should-really-be-afraid-of/
113
“Keynes, Lerner & the Question of Public Debt,” https://varoufakis.files.wordpress.com/2014/01/ta-on-debt-paper-1.pdf
114
Quoted by Tony Aspromourgos, “Keynes, Employment Policy and the Question of Public Debt,” Rev.of Pol.Ecy [2014]
http://dx.doi.org/10.1080/09538259.2014.938440 p.586.
115
“...private debt differs from national debt in being external. It is owed by one person to others. That is what makes it burdensome.
Because it is interpersonal the proper analogy is not to national debt but to international debt…. But this does not hold for national debt
which is owed by the nation to citizens of the same nation. There is no external creditor. We owe it to ourselves. A variant of the false
analogy is the declaration that national debt puts an unfair burden on our children, who are thereby made to pay for our extravagances.
Very few economists need to be reminded that if our children or grandchildren repay some of the national debt these payments will be
made to our children or grandchildren and to nobody else. Taking them altogether they will no more be impoverished by making the
repayments than they will be enriched by receiving them.” Abba Lerner The Burden of the National Debt (1948)
https://rwer.wordpress.com/2017/07/24/the-balanced-budget-paradox/ His theory is called “functional finance.”
116
David Colander, “Was Keynes a Keynesian or a Lernerian?”JE; 1984, 1574. https://www.jstor.org/stable/2725382
117
General Theory, 378. Quoted in http://www.skidelskyr.com/site/article/the-relevance-of-keynes/
118
Jack Dwyer, Keynes’s economics and the question of public debt,
https://ses.library.usyd.edu.au/bitstream/2123/8007/1/Jack%20Dwyer%20thesis.pdf 19-20.
119
Kregel, quoted by Dwyer, 20.
120
http://realmoney.thestreet.com/articles/07/20/2016/social-security-if-it-aint-broke-...-and-it-aint-and-it-never-will-be
121
“While the US government is busy driving up its “sovereign” debt and the interest owed on it, Japan has been canceling its debt at the
rate of $720 billion (¥80tn) per year. How? By selling the debt to its own central bank, which returns the interest to the government.
....As noted by fund manager Eric Lonergan in a February 2017 article: ....Japan has a record low inflation rate of .02 percent. That’s not
2 percent, the Fed’s target inflation rate, but 1/100th of 2 percent – almost zero. Japan also has an unemployment rate that is at a 22-year
low of 2.8%, and the yen was up nearly 6% for the year against the dollar as of April 2017. Selling the government’s debt to its own
central bank has not succeeded in driving up Japanese prices, even though that was the BoJ’s expressed intent.”
https://www.counterpunch.org/2017/06/29/sovereign-debt-jubilee-japanese-style/
122
https://real-economics.blogspot.com/2017/04/private-banks-create-virtually-all-money.html
123
Agent Based-Stock Flow Consistent Macroeconomics: Towards a Benchmark Model
http://www8.gsb.columbia.edu/faculty/jstiglitz/sites/jstiglitz/files/Agent%20Based-Stock%20Flow%20Consistent%20Macroeconomics-
%20Towards%20a%20Benchmark%20Mode.pdf
124
https://www.federalreserve.gov/monetarypolicy/reservereq.htm 10% reserve requirement for banks with deposits exceeding $115
million.
125
Keynes believed supply bottlenecks or wage/profit push might lead to inflation before full employment, anticipating stagflation.
126
Tcherneva, “Permanent On-The-Spot Job Creation—The Missing Keynes Plan for Full Employment and Economic Transformation,”
Review of Social Economy, 70 (1) 66 http://dx.doi.org/10.1080/00346764.2011.577348, 65-6. Keynes, Collected Wks, v.27, 303.
127
Tcherneva, “Permanent On-The-Spot Job Creation,” op. cit http://dx.doi.org/10.1080/00346764.2011.577348, Keynes, Collected Wks,
v.21, 395 & 409.
128
Tcherneva, Keynes’s Approach to Full Employment: Aggregate or Targeted Demand? Levy, Working Paper No. 542, 8/08, p.4.
129
Keynes’s Approach to Full Employment: Aggregate or Targeted Demand? www.levyinstitute.org/pubs/wp_546.pdf p. 3
130
Doug Henwood: “At 2.1% of GDP in 2016, total net fixed investment is just over half its 1950–2000 average of 3.8%; at 1% of GDP,
investment in equipment is more than a third below its average over the same period of 1.6%..... The recent peak of 2.7% in total
investment, set in 2014, was below the recession lows of 1975 and 1983.... In other words, in the best recent year, corporations invested at
a rate matched or exceeded in earlier bad years. Not graphed is investment in structures ...whose trajectory is very similar to equipment.
Its 2016 share of GDP, 0.6%, was a third its 1950–2000 average. Intellectual property (IP) investment...[has] been rising as a share of
GDP, but it remains a tiny 0.5%. When it comes to its social benefits, it’s a mixed bag. About half of it, 47% in 2016, is accounted for by
software, both commercial and custom-made. Some software is useful, like the WordPress code that makes this blog possible and the
Excel and Illustrator code that made the above graph possible, but some is overpriced and bloaty....A bit less, 42% last year, is research
and development (R&D). Some R&D produces useful products, but an awful lot of it is just the pursuit of rents from branding and patent
scheming. (The leading culprit here is the pharmaceutical industry, whose basic research is largely funded by governments and
universities....) And the remaining 11% is accounted for by “entertainment, literary, and artistic originals,” which includes Game of
 19

Thrones .... While these can produce pleasure, their contribution to long-term prosperity is hard to measure.
https://jacobinmag.com/2017/09/private-investment-profits-united-states
131
Wolfgang Streeck, a German economic sociologist, “The Return of the Repressed,” NLR104, March-April 2017
132
Larry Summers, Timothy Geithner, and Gary Gensler, among others. http://www.whiteoutpress.com/articles/q42012/list-of-goldman-
sachs-employees-in-the-white-house/
133
Steve Mnuchin,, Treasury, and Gary Cohn, Director, NEC. Strategist Steve Bannon is also from Goldman
.https://theintercept.com/2017/07/15/trumps-team-overseeing-wall-street-brings-in-more-goldman-sachs-alumni-docs-reveal/
134
Along with Rubin and Summers. http://content.time.com/time/covers/0,16641,19990215,00.html
135
https://blogs.crikey.com.au/us08/2008/10/24/the-end-has-begun-“i-was-shocked…i’ve-found-a-flaw/ from
https://www.gpo.gov/fdsys/pkg/CHRG-110hhrg55764/html/CHRG-110hhrg55764.htm Nomi Prins quote, It Takes a Pillage, 121. He
considered laws against financial fraud unnecessary—“the market would take care of itself “Well, you probably will always believe there
should be laws against fraud, and I don’t think there is any need for a law against fraud,” she recalls. Greenspan, Born says, believed the
market would take care of itself.” Born headed the Commodity Futures Trading Commission.
https://alumni.stanford.edu/get/page/magazine/article/?article_id=30885
136
https://www.socialeurope.eu/2017/05/needed-progressive-vision-national-sovereignty/ The Financial Crisis Inquiry Commission
concluded, http://www.nytimes.com/2011/01/26/business/economy/26inquiry.html “’The greatest tragedy would be to accept the refrain
that no one could have seen this coming and thus nothing could have been done.’ ...regulators ‘lacked the political will’ to scrutinize and
hold accountable the institutions they were supposed to oversee.”
137
Anatole Kaletsky, “The Crisis of Market Fundamentalism,” https://www.socialeurope.eu/2017/01/crisis-market-fundamentalism/

View publication stats

The Nature of Competition and the Scope of Firms
Author(s): Asher Wolinsky
Source: The Journal of Industrial Economics, Vol. 34, No. 3 (Mar., 1986), pp. 247-259
Published by: Wiley
Stable URL: https://www.jstor.org/stable/2098569
Accessed: 22-01-2020 10:00 UTC

REFERENCES
Linked references are available on JSTOR for this article:
https://www.jstor.org/stable/2098569?seq=1&cid=pdf-reference#references_tab_contents
You may need to log in to JSTOR to access the linked references.

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide
range of content in a trusted digital archive. We use information technology and tools to increase productivity and
facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected].

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at
https://about.jstor.org/terms

Wiley is collaborating with JSTOR to digitize, preserve and extend access to The Journal of
Industrial Economics

This content downloaded from 203.129.195.130 on Wed, 22 Jan 2020 10:00:06 UTC
All use subject to https://about.jstor.org/terms
THE JOURNAL OF INDUSTRIAL ECONOMICS 0022-1821 $2.00
Volume XXXIV March 1986 No. 3

THE NATURE OF COMPETITION AND THE SCOPE

OF FIRMS

ASHER WOLINSKY

This paper examines how the scope of firms in an industry is affected by

the nature of the competition in that industry. The main observation is
that imperfectly competitive conduct introduces additional incentives (as
compared to competition among price takers) to form multi-product
firms. This is explained by the fact that imperfect competition often
creates "excess capacities" which in turn induce the firms to expand into
other markets.

I. INTRODUCTION

THE RECENT studies of multi-product industries have exposed the technological

determinants of the structure of such industries (see, for example, Panzar and
Willig [1979], [1981], and Baumol, Panzar and Willig [1981]). These studies
introduce the concept of economies of scope (when there are economies of
scope it is less costly to combine two or more product lines in one firm than
to produce them separately) and relate it to the structure of firms in classical
competitive equilibrium. They show that the cost-side property of economies
of scope is both a necessary and a sufficient condition for the formation of
multi-product firms in perfectly competitive markets.
A natural extension is to investigate how additional factors such as the
nature of demand and the conduct of firms supplement cost considerations in
determining the scope of firms. The present paper proceeds in this direction
by suggesting a certain explanation for how the scope of firms may depend
on the nature of the competition in the industry. In particular we argue that
imperfectly competitive conduct introduces additional incentives (as com-
pared to those existing in perfect competition) to form multi-product firms.
This point is demonstrated by a model of an industry in which competitive
behavior results in complete specialization, but at the imperfectly competitive
(Cournot) free-entry equilibrium there may be multi-product firms.
The idea is that imperfect competition in a market for a single product
often leads to firms' excess capacity. This is due to the competitors' tendency
to cut back production and possibly also due to strategic choice of capacities
(see, for example, Dixit [1980]). As noted in the classic works of Clark [1923]
and Clemens [1958], excess capacity is a reason for the emergence of a
multi-product firm, since a firm will try to exploit its excess capacity for the
production of other products.
The implications of the analysis of the present paper are potentially test-

247

This content downloaded from 203.129.195.130 on Wed, 22 Jan 2020 10:00:06 UTC
All use subject to https://about.jstor.org/terms
 248 ASHER WOLINSKY

able. In particular, it suggests that measures of the degree of competition,

such as the degree of concentration or the size of the barriers to entry, may
serve as explanatory variables for the scope of firms across industries.
The plan of the paper is as follows. Section II presents a model of a
two-product industry with two types of production technologies. Each
technology can be used to produce both products, but each is more efficient
in the production of a different product.
Section III considers two alternative forms of competition: competition
among price taking firms and imperfect competition (Cournot behavior). For
each form of competition the equilibrium with respect to entry, choice of
technology and produced quantities is characterized. The main observation
is that the scope of firms in equilibrium depends upon the nature of
competition in the industry. With the technologies assumed here, price taking
firms would specialize at equilibrium in one product or the other, while the
imperfectly competitive equilibrium may give rise to multi-product firms.
The intuition behind this result is discussed in section IV. It has to do with
the fact that Cournot competition results in excess capacity in the sense that
the equilibrium prices are above marginal costs.
Finally, section V is devoted to a discussion that relates the results of the
present paper to the cost-side property of economies of scope which is central
to the discussion of multi-product firms in the existing literature.

II. THE MODEL

Consider an industry that consists of two products 1,2 which can be

produced jointly. Suppose that there are two types of technology (say, each
involving a different type of specific capital equipment) such that technology
i, i = 1,2, is more efficient in producing product i. The use of technology i
involves a fixed cost F. The variable cost of producing quantities xi of
product i and yi of product j with technology type i is given by c'(x', yi). It is
assumed that Ci is convex, c, > 0, C, > 0, ci2 > 0 and c'1 > ci2, ci2 > ci2,
where superscripts refer to the type of technology or product, and subscripts
denote partial derivatives. To capture the idea that technology i is more
efficient in producing product i, it is assumed that

(1) cii (xi, yi) < ci2(xi, yi) for all xi, yi > 0
It is easy to verify that (1) implies that for any s > 0, ci(x, y) > ci(x + ?, y - ?)
and in particular c'(x +y, 0) < c'(x, y). To understand the meaning of the cost
assumptions consider briefly the particular example c y(xJ)- C(xi + y) +
V(yi) where C'( ) > 0, V'( ) > 0, C"( ) > 0, V"( ) > 0. This example is easy
to interpret: products i and j share the same facilities and incur the same basic
cost C( ), but the production of j with technology i requires some special
adjustment effort which is captured by V(yi).
Let pi( * ) denote the inverse demand for product i and assume that the

This content downloaded from 203.129.195.130 on Wed, 22 Jan 2020 10:00:06 UTC
All use subject to https://about.jstor.org/terms
 COMPETITION AND THE SCOPE OF FIRMS 249

demands for the two products are independent. To avoid later on a technical
discussion which is not our main interest, it is assumed that pi() is concave
(or linear).
Finally, we assume complete symmetry: pl(.) = p2( ) = p(), F' = F2 = F
and c'(x, y) = c2(x, y) = c(x, y) where the latter means that the cost of
producing x' = x and y2 = y with technology 1 is equal to the cost of
producing x2= x and y' = y with technology 2. (Notice that our notational
convention is that the first coordinate of c(-, ) is the quantity of the product
at which the considered technology is more efficient.)
It should be emphasized that our purpose is to obtain a simple model that
will enable us to focus on the main point, without dealing with additional
complications which are not directly relevant for that point. For this reason
we invoked quite strong assumptions, such as the limitation to two products
and the independence of the demands. These assumptions are not essential
for the derivation of the qualitative results, but they simplify the exposition
substantially.

III. THE SCOPE OF FIRMS IN PERFECT AND IMPERFECT COMPETITION

The purpose of this section is to examine how the nature of the competition
affects the scope of firms in the context of the model outlined above. To this
end we suppose that there are many potential firms that have access to the
same technologies (as captured by the function c(-, .)) and consider the
equilibrium outcomes under two alternative forms of competition. One form
is competition among price takers which will be referred to as perfect
competition. The other form is competition among Cournot-type quantity
setting firms that recognize the effect of their actions on the prices and we
shall refer to it as imperfect competition. In both cases we consider the free
entry equilibrium in which the number of firms is determined endogenously
by the zero-profit condition.

Perfect competition

Suppose that there are many potential entrants. Each has to decide whether
or not to enter the industry (an entrant incurs the set-up cost F) and then
which technology to employ and what quantities to produce. The behavioral
assumption is that the firms are price takers. That is, given the prices p' and
p2, the profit maximization problem of a firm that chose technology i is

(2) Max {p'x' + pjyJ - c(x, yi) - F}

The necessary conditions for xi and yi to be the solution to this problem are:

pi < cl (xi, yi) with equality holding if xi > 0

pi < c2(Xi, y) with equality holding if yi > 0

This content downloaded from 203.129.195.130 on Wed, 22 Jan 2020 10:00:06 UTC
All use subject to https://about.jstor.org/terms
 250 ASHER WOLINSKY

These conditions together with the condition that each firm chooses its
technology optimally and the free entry (zero-profit) condition characterize
the competitive industry's equilibrium. It can be verified that if c1 1 > 0 and
the fixed cost F is not "too large", then there exists a unique industry
equilibrium (in our statements concerning the equilibrium we ignore integer
problems which may arise due to the fact that, with an integer number of
firms, the requirement of zero-profit may not be satisfied precisely). This
unique equilibrium is of the following form: the prices of both products are
the same, pi = p2 = p*; a firm with technology i produces quantity xi = x*
such that c (x*, 0) = p*, and quantity yi = 0 of the other product; by the
zero-profit condition p* is equal to the average cost [c(x*, 0) + F]/x*.
To verify the above statements note first that at equilibrium we cannot have
yi > 0. This is because with technologies of the type considered here (see (1)
above), for all yi > 0 the equality p* = c1 (xi, yi) implies p*< C2(Xi, yi). Thus,
since profit maximization of a price taking firm with technology i implies
p* = cI(x', yi), it also implies p*< C2(Xi, yi) and hence yi = 0. Next, note that
the requirement that c1I > 0 guarantees that when a firm with technology i
produces only product i, its marginal cost function is strictly increasing.
Therefore, the case of c1,1 > 0 is the standard textbook case of a competitive
industry equilibrium with U-shaped average cost curves. That is, when
integer problems are ignored, the unique equilibrium prices are equal to
minimum average cost and the number of firms is such that the demand is
satisfied when all active firms operate at minimum average cost. The
requirement that F is not "too large" is then needed to guarantee that at a
price equal to minimum average cost, the demanded quantity is sufficient to
sustain the industry.
Similarly, it is easy to verify that for the case of c11 = 0 and F = 0 there
also exists a unique competitive equilibrium. This is the standard case of
constant marginal cost: the unique equilibrium here is also such that each
firm produces a single product; the equilibrium prices are equal to the
constant marginal cost c1; but the number of firms is indeterminate.
The conclusion is that in the industry considered here competition among
price takers, or for that matter any form of competition that results in
marginal cost pricing (see the discussion of this point at the end of the
section), leads to complete specialization.

The imperfectly competitive case

As before, the firms that enter the market choose simultaneously which
technology to employ and what quantities to produce of products 1, 2. But
here each firm is aware that its actions affect the prices. The equilibrium
concept is Nash equilibrium with quantities and the choice of technology as
the strategic variables, and with the additional requirement of zero profit,
which together with the assumption of free entry determines the equilibrium

This content downloaded from 203.129.195.130 on Wed, 22 Jan 2020 10:00:06 UTC
All use subject to https://about.jstor.org/terms
 COMPETITION AND THE SCOPE OF FIRMS 251

number of firms. Namely, each firm chooses technology and quantities so as

to maximize its profits, given the quantities chosen by the others, and entry
continues until all profits are exhausted.
We shall focus on symmetric equilibria. A symmetric equilibrium is a
configuration of 2n firms where n firms employ technology 1, the other n
employ technology 2, and each firm with technology i produces xi = x* and
yi = y* of products i and j respectively. It will be convenient to denote by
9 (x i I Qi = A, Qj = B) the profits of a firm with technology i who produces
xi and yi, given that the total quantities of products i,j offered by its rivals are
A and B respectively. Define q = (n-1)x* +ny* and Q = nx* + (n -1)y*.
The conditions which must be satisfied at a symmetric equilibrium are:

(3) JCi(x* y * IQi = q, Qi = Q) >, nci(x', yi IQ' = q, Qi = Q) for all xi, yi

(4) 2ri(x* y*IQi = q, Qj = Q) > 7ri(xi,yilQi = q, Qj = Q) for all xi, y
(5) 7ri(x*, y*Qi = q, Qi = Q) = 0
Condition (3) requires that, given a firm's technology and the quantities
produced by its rivals, its profit is maximized at the equilibrium quantities
x* and y*. Condition (4) requires that the firm's profit is maximized with
respect to the choice of its technology. Condition (5) is the equilibrium
zero-profit condition which ensures that no further entry is profitable.
If such an equilibrium exists, then x*, y* and n are characterized by the first
order conditions and the zero profit condition:

(6) p(nx* + ny*) + x*p'(nx* + ny*) = cl (x*, y*)

(7) p(nx* + ny*) +y*p'(nx* + ny*) < C2(X*, y*)
and the equality holds if y* > 0

(8) (x* +y*)p(nx* + ny*) - c(x*, y*) + F

where p'( . ) denotes the first derivative of p( )
Of course, a pre-condition for the existence of a non-degenerate equilibrium
of this type is that F is not "too large" so that some firms can profitably
coexist in the industry. Supposing that F is indeed such that at least two firms
can coexist, we have:

Claim 1: Ignoring integer problems there exists a symmetric zero profit equi-
librium. (The proof is sketched in the appendix.)

Let us examine the scope of firms at the imperfectly competitive equi-

librium. Inspection of the necessary conditions (6)-(8) reveals that the
symmetric equilibrium may involve either specialization or joint production.
That is, for certain values of the parameters, the equilibrium output of each
firm consists of positive quantities of both products (x* > 0, y* > 0), while
for other values of the parameters each firm will specialize, at equilibrium, in
the product at which it is more efficient (x* > 0, y* = 0).
It will be useful to observe the two possibilities by considering the follow-

This content downloaded from 203.129.195.130 on Wed, 22 Jan 2020 10:00:06 UTC
All use subject to https://about.jstor.org/terms
 252 ASHER WOLINSKY

ing two examples. First, consider the functional form c(x, y) = C(x +y) +y2.
It is easy to verify that in this case the firms will always produce both
products at equilibrium. The property of this cost function which gives rise
to the joint production is the fact that c1 (x, 0) = C2(X,O). To see this suppose
that the firms specialized at -equilibrium and let p* denote the symmetric
equilibrium price. Notice that equation (6) implies c1(x*,O) < p* which
together with the quality of the marginal costs means that c2(x*, 0) < p*
But the last inequality means that it pays the firm to produce some positive
quantity of the other good and hence specialization cannot be an equilibrium
result.
Next, consider a cost function, c(x, y), for which c2(x, 0) is bounded away
from c1(x, 0), as is the case for the functional form c(x, y) = C(x +y) + ry. In
this case, depending on the parameters of the model, the equilibrium may
involve either specialization or joint production. When the fixed cost F is
relatively large, the equilibrium number of firms is relatively small, and at
equilibrium firms will produce both products. This is because, with a
relatively small number of firms, specialization will result in relatively high
mark-ups of prices over marginal costs. If the mark-up is in excess of r, firms
will be induced to start producing the other good, since the marginal cost of
producing it is lower than the price it fetches. Hence, when the size of the fixed
cost dictates a relatively small number of competitors, specialization cannot
be an equilibrium result. By the same reasoning, when the fixed cost F is
small and hence the equilibrium number of firms is relatively large, the firms
will specialize.
These points concerning the relations between the intensity of competition
(as measured by the equilibrium number of firms) and the pattern of
specialization are easily demonstrated by the simple example where c(x, y) =
c (x +y) + ry and the demand functions are linear p' (z) = p2(Z) = a-bz.
Using the equilibrium conditions one can calculate the symmetric equilibrium
magnitudes of n (the number of firms of each type), x* and y*. When the
set-up cost F is sufficiently large and hence n is sufficiently small to satisfy
n < [(a - c)/r] -1, then at equilibrium each firm produces both products in
quantities x* = (a-c + nr)/b(2n + 1) and y* = (a-c-(n + 1)r)/b(2n + 1) re-
spectively. As n is made larger (that is, F is made smaller) the ratio y*/x*
approaches zero, and as n reaches the critical value [(a - c)/r] -1 complete
specialization is achieved. In this sense one can say that a more intense com-
petition results in a greater degree of specialization. Note that the equilibrium
number of firms does not depend only on the size of the set up cost F but
rather on the size of F relative to the extent of the market. Thus, for the class
of cases considered here, one may say that, given the size of F, the degree of
specialization is determined by the extent of the market. This observation
suggests another interpretation for the idea that "the division of labor is
limited by the extent of the market", which was discussed by Stigler [1951]
in the context of vertical disintegration.

This content downloaded from 203.129.195.130 on Wed, 22 Jan 2020 10:00:06 UTC
All use subject to https://about.jstor.org/terms
 COMPETITION AND THE SCOPE OF FIRMS 253

The next section contains a discussion of the above comparison between

the scope of firms under the two forms of competition. Before we turn to the
discussion, let us comment on the meaning of the comparison between the
two forms of competitive behavior (price taking behavior vs. quantity setting
behavior). First, the comparison should not be taken to imply that the two
forms of competition are as likely nor is there any attempt to explain what
circumstances give rise to any one of the forms of competitive behavior.
Rather, the main point is that imperfectly competitive conduct which results
in non-marginal cost pricing may have some implications for the scope of
firms and a convenient way to demonstrate it is by comparison to the bench-
mark case of competition among price takers.
Second, the feature of perfect competition which is utilized in the compari-
son is the equality of the equilibrium prices to marginal costs. However,
marginal cost pricing could be the result of other types of competition.
Grossman [1981] has shown that certain forms of strategic interaction
among (possibly only a few) firms that are not price takers may drive them
to marginal cost pricing. Grossman explains the difference between the
strategic interaction suggested by his model and the Cournot interaction as
resulting from different types of contracts between sellers and buyers which
are available in the market. Thus, the points made by the present paper are
also valid if the above comparison is interpreted as referring to two forms of
imperfectly competitive interactions which take place in markets with similar
basic conditions but different contractual arrangements.

IV. DISCUSSION

The main observation made in the previous section is that imperfectly

competitive conduct may lead to the formation of multi-product firms in an
industry in which competition among price takers would result in complete
specialization. The key to this result lies in the fact that competition among
Cournot-type quantity setting firms results in equilibrium prices above mar-
ginal costs (this is, of course, due to the fact that each firm faces a downward
sloping residual demand curve and hence maximum profit is achieved at the
quantity at which the marginal revenue is equal to the marginal cost). As a
consequence of the discrepancy between price and marginal cost even a firm
which is somewhat less efficient can produce some positive quantity of that
product and cover the variable cost that it incurs in doing so. The implication
of this argument for the two-product industry considered here is that a firm
which is more efficient in producing product i may sometimes profitably
exploit the gap between the price and marginal cost in the market for product
j and produce some quantity of that product. To see this argument more
precisely consider the symmetric industry equilibrium which is obtained
when the firms are artificially constrained to produce one product. In this
equilibrium there are n firms of each type; every firm produces quantity x* of

This content downloaded from 203.129.195.130 on Wed, 22 Jan 2020 10:00:06 UTC
All use subject to https://about.jstor.org/terms
 254 ASHER WOLINSKY

the product at the production of which it is more efficient; and the prices are
p*-pl(nx*) = p2(nx*). Notice that if c2(x*, O) < p*, then it pays a producer
of product 1 to produce also a unit of product 2 despite the facts that the price
of this unit, p2, is not higher than p1 (since p' = p2 = p*), and its production
is more costly than the production of an additional unit of product 1. The
reason that the firm wants to produce this more costly unit of product 2, but
does not want to increase its production of product 1 is that the marginal
revenue that accrues to the firm in market 2 is the price p* which is greater
than the marginal revenue, p* + x*(dpl/dx), it obtains in market 1.
The above explanation suggests that the results of section III do not just
reflect some peculiar properties of the simple model employed there. Rather,
the driving forces such as the firms' tendency to restrict their output and the
existence of price mark-up over marginal cost are quite common character-
istics of imperfectly competitive markets.
In the light of this it is quite obvious that some of our assumptions are not
crucial for the derivation of the qualitative results but rather serve to simplify
the analysis. For example, consider the possibility to relax the assumption
that the demands for the two products are independent. If the price of each
product is assumed to depend on the total quantities of both products, then
the qualitative results concerning the scope of firms under the two forms of
competition do not change. The only difference is that whether or not
imperfectly competitive conduct results in the emergence of two-product
firms in any particular case will now also depend on the cross demand
effects in that case. Note that the above remains true when the two products
are complementary. This is because the argument given in section III for why
price takers specialize is not affected (it depends only on the cost advantages
to specialization), while the possibility that imperfect competitors will pro-
duce both products is just enhanced by the complementarity.
Next, let us consider the issue of efficiency. Provided that the rest of the
economy (that is, all markets other than the markets for goods 1 and 2) is
competitive, the imperfectly competitive conduct in the markets for goods 1
and 2 results in an inefficient allocation. Two of the distortions which exist in
this case are not special to the present model. These are the allocative
inefficiency which is due to the fact that the imperfectly competitive sector
produces too little and the productive inefficiency which has to do with the
fact that, given the industry's output, the industry's cost is not necessarily
minimized with respect to the number of firms. An additional aspect of
inefficient production, which is special to the present model, has to do with
the existence of multi-product firms despite the cost advantages to specializa-
tion. That is, given the equilibrium number of active firms and the total
industry output, the industry cost is not minimized with respect to specializa-
tion. A reorganization of production whereby each firm produces the same
volume but specializes in a single product will facilitate the production of the
same outputs at lower industry costs. Since the latter distortion is added to

This content downloaded from 203.129.195.130 on Wed, 22 Jan 2020 10:00:06 UTC
All use subject to https://about.jstor.org/terms
 COMPETITION AND THE SCOPE OF FIRMS 255

the distortions that would have existed anyway, one cannot say in general
whether or not the possibility of joint production improves the allocation.
That is, letting welfare be measured by total surplus (the sum of consumers'
surplus and profits), it can be shown that if the firms are forced to specialize
the total surplus can be either lower or higher (depending on the various
parameters) than it is when joint production is allowed. This is because the
existence of multi-product firms might lead to higher output and hence
higher consumers' surplus, but it involves higher costs of production which
may or may not outweigh the added consumers' surplus.
The above-described inefficiency which may arise in competition among
multi-product firms is, of course, due to the nature of the costs of production
assumed throughout (see (1)). For a complementary discussion concerning
the efficiency aspects of competition among multi-product firms the reader is
referred to Waterson [1983], who considers industries in which the cost
conditions are favorable to multi-product production and analyzes the
efficiency tradeoff between economies of scope and the effects of market
power.

V. ECONOMIES OF SCOPE

The modern literature on multi-product firms has dealt mainly with the
technological (cost side) determinants of the structure of such firms. The
present paper has exposed another determinant of the scope of firms-the
nature of the competition in the industry. The purpose of this section is to
consider the connection between the results of the present paper and the
technological property of economies of scope which is a central concept in the
literature referred to above.
Let us start by describing the concept of economies of scope in the context
of the two-product industry considered here (Panzar and Willig who coined
this term discuss it for arbitrary number of products). It is said that there are
economies of scope at the output combination xi, yi if the cost of producing
this combination by one firm is lower than the cost of producing it by two
single-product firms. That is,

(9) F+c(x', yi) < F+c(xi, O)+F+c(yi, O)

In Baumol, Panzar and Willig [1981] the property of economies of scope is

related to the structure of firms in classical competitive equilibrium. Their
two propositions are: (a) if at a competitive equilibrium there exist single-
product firms that produce x' and y2 respectively, then there are no
economies of scope at the combination (x', y2); (b) if at a competitive
equilibrium there exists a firm that produces the combination (xI, y2), then
there are weak economies of scope (with weak inequality in (9)) at this

This content downloaded from 203.129.195.130 on Wed, 22 Jan 2020 10:00:06 UTC
All use subject to https://about.jstor.org/terms
 256 ASHER WOLINSKY

combination. The proofs of these propositions follow immediately from the

definitions of economies of scope and competitive equilibrium.
The proposition quoted above does not refer to the relations between the
scope of firms and the property of economies of scope in imperfectly
competitive markets. In general there is no reason to expect that the existence
of economies of scope is a necessary condition for the formation of multi-
product firms in imperfect competition. This is because in an imperfectly
competitive market the firms may be guided by strategic considerations such
as the desire to deter entry by brand proliferation (see, for example,
Schmalensee [1978], Scherer [1980] and the references therein). Such con-
siderations may induce firms to multi-product production even in the
absence of economies of scope. However, in the model considered here, the
firms do not have strategic considerations of that type and indeed the
existence of two-product firms is related to the property of economies of
scope.

Claim 2: A necessary conditionfor the existence oftwo-productfirms at the

imperfectly competitive equilibrium of section IV is that, at thefirm's equilibrium
output vector, the costfunction exhibits economies of scope.

Proof: Suppose that in the imperfectly competitive equilibrium of section

IV each firm produces positive quantities of both products. Let x*, y* denote
the quantities of i,j respectively which are produced by a firm with tech-
nology i, and let p = p(nx* + ny*) denote the equilibrium price.
Following the definition of economies of scope, we have to show that it is
cheaper to produce these quantities together than to produce them separately,
that is,

c(x*, y*) + F < c(x*, 0) + F + c(y*, 0) + F

From the fact that (x*, y*) maximizes each firm's profit and from the
zero-profit condition we have
(10) px*-c(x*, 0) < px* + py*-c(x*, y*) = F

Since y* < x* and cl(x*, 0) < cl(x*, y*) < p we have

py*-c(y*, 0) < px*-c(x*, 0) < F
Therefore, py* < c(y*, 0) + F, which together with (10) implies that

c(x*, y*) + F = px* + py* < c(x*, 0) + F + c(y*, 0) + F Q.E.D.

By definition, economies of scope is a "local" property of the cost

function-at certain output vectors the cost function may exhibit economies
of scope, while at others it may not. With the technology assumed here,
imperfect competition may result in each firm producing an output combina-
tion at which there are economies of scope, while perfect competition results
in specialization. This is not surprising since, as suggested by Panzar and

This content downloaded from 203.129.195.130 on Wed, 22 Jan 2020 10:00:06 UTC
All use subject to https://about.jstor.org/terms
 COMPETITION AND THE SCOPE OF FIRMS 257

Willig [1981], economies of scope are explained by the existence of "quasi-

public" input which can be interpreted as some type of excess capacity. But,
imperfect competition often leads to the existence of excess capacities which,
in turn, give rise to economies of scope.
It is now possible to examine the role of our main assumption concerning
the cost side (that is, that for all x and y, c1(x, y) < c2(x, y)). In the absence
of such an assumption the conclusion that competition among price takers
results in specialization does not necessarily hold. Furthermore, with arbi-
trary cost functions, one cannot exclude pathological cases such that at the
output combinations produced by the firms in the perfectly competitive
equilibrium there are economies of scope, while at the output combinations
of the Cournot equilibrium there are diseconomies of scope. Such cost
structures are indeed pathological, since the most natural source of economies
of scope are excess capacities (see Panzar and Willig [1981]) which do exist
in Cournot equilibrium but do not exist in perfectly competitive equilibrium.
Thus, if the above assumption is abandoned and all possible cost structures
are considered, then it is still true that imperfectly competitive behavior
creates additional incentives (as compared with price taking behavior) for
firms to expand their scopes. However, these additional incentives just
supplement the technological factors and therefore do not guarantee that
under imperfect competition the scope of firms will be always larger than it is
under perfect competition.

VI. CONCLUSION

This paper has examined how the scope of firms is affected by the nature of
the competition in the industry. In the context of the model studied here it
was shown that imperfectly competitive conduct may lead to the formation
of multi-product firms in an industry in which perfect competition results in
specialization. The qualitative conclusion is that imperfectly competitive
behavior creates additional incentives (as compared with perfectly competi-
tive behavior) for firms to expand their scopes. These incentives supplement
cost considerations which are the only relevant data for understanding the
scope of firms under perfect competition. The implications of this paper are
potentially testable in the sense that one can use a measure of the degree of
competition as one of the explanatory variables for the differences in the
scope of firms across industries.

ASHER WOLINSKY, ACCEPTED MAY 1985

The Faculty of Social Sciences,
Department of Economics,
The Hebrew University of Jerusalem,
Mount Scopus,
Jerusalem 91905,
Israel.

This content downloaded from 203.129.195.130 on Wed, 22 Jan 2020 10:00:06 UTC
All use subject to https://about.jstor.org/terms
 258 ASHER WOLINSKY

APPENDIX

Proof of Claim 1

Consider first a configuration of 2n firms such that n employ technology 1 and the
other n technology 2. With n and the technologies fixed, the convexity of c(, ), the
concavity of p( * ) and the complete symmetry imply that there exists a symmetric equi-
librium with respect to the choice of quantities (this follows from standard arguments
which are brought, for example, in Friedman [1977]). Further, since c1l > c12 and
C22 > c12 it can be shown that, for a given n, there is only one such symmetric
equilibrium (upon differentiating the first order conditions for a symmetric equi-
librium, one can observe that these properties of cost together with the aforementioned
properties imply a unique solution).
To see that this configuration is at equilibrium with respect to the choice of
technology as well, it has to be shown that, given the quantities produced by all other
firms, no firm can profit from changing both its technology and quantities. Suppose
that at the quantity equilibrium with fixed n and fixed technologies, a firm with
technology i produces x* of product i and y* of product j. It follows from the first
order conditions (6) and (7) that x* > y*. Consider now a firm with technology 1. The
total quantities produced by all other firms Q', Q2 are Q1 = (n - 1)x* + ny* < nx* +
(n- 1)y* = Q2. Suppose that the firm switches to technology 2 and produces
quantities z, w of products 1,2 respectively. If z > w then c1(z, w) < c2(w,5z) imp
that r2(w, z) < 7r' (x* y*
Ifz < w,then

x2(W, Z)_- x'(W, Z) = p(Q2 + W)W + P(Ql + Z)Z-p(Ql + W)W _p(Q2 + Z)z
= [p(Q1 +z)_p(Q2 +z)] _ [p(Q1 +W)_p(Q2 +W)] < 0
where the last inequality follows from w > z, Q2 > Q' and the concavity of p( ).
Therefore, 7r2(w,z) < x'(w,z) < xl(x*, y*) and the switch of technology is unprofit-
able. So far we have shown that, for any given n, there exists a symmetric configuration
satisfying conditions (3) and (4). Now, ignoring integer problems, n can be raised
(lowered) until the per-firm profit sufficiently falls (rises) so as to satisfy the zero-profit
condition (5).
Q.E.D.

REFERENCES

BAUMOL, W., PANZAR, J. and WILLIG, R., 1981, Contestable Markets and the Theory of
Industry Structure (Harcourt Brace Jovanovich, San Diego).
CLARK, J., 1923, Studies in the Economics of Overhead Costs (Chicago University
Press).
CLEMENS, E., 1958, 'Price Discrimination and the Multiproduct Firm', reprinted in
R. Heflebower and G. Stocking (eds.), AEA Readings in Industrial Organization
and Public Policy, pp. 262-276 (Homewood, Illinois).
DIXIT, A., 1980, 'The Role of Investment in Entry Deterrence', Economic Journal, 90,
pp. 95-106.
FRIEDMAN, J., 1977, Oligopoly and the Theory of Games (North-Holland, Amsterdam).
GROSSMAN, S., 1981, 'Nash Equilibrium and the Industrial Organization of Markets
with Large Fixed Costs', Econometrica, 49, 5, pp. 1149-1172.
PANZAR, J. and WILLIG, R., 1979, 'Economies of Scope, Product Specific Economies of
Scale and the Multi-Product Competitive Firm', Bell Labs Economic Discussion
Paper No. 152.

This content downloaded from 203.129.195.130 on Wed, 22 Jan 2020 10:00:06 UTC
All use subject to https://about.jstor.org/terms
 COMPETITION AND THE SCOPE OF FIRMS 259

PANZAR, J. and WILLIG, R., 1981, 'Economies of Scope', American Economic Review,
71, 2, pp. 268-272.
SCHERER, F., 1980, Industrial Market Structure and Economic Performance (Second
Edition, Rand McNally, Chicago).
SCHMALENSEE, R., 1978, 'Entry Deterrence in the Ready-to-Eat Breakfast Cereal
Industry', Bell Journal of Economics, 9, 2 (Autumn), pp. 305-327.
STIGLER, J., 1951, 'The Division of Labor is Limited by the Extent of the Market',
Journal of Political Economy, 59, pp. 185-193.
WATERSON, M., 1983, 'Economies of Scope within Market Frameworks', International
Journal of Industrial Organization', 1, pp. 223-237.

This content downloaded from 203.129.195.130 on Wed, 22 Jan 2020 10:00:06 UTC
All use subject to https://about.jstor.org/terms
 BACK TO BASICS

What Is Keynesian
Economics?
The central tenet of this school of thought is that
government intervention can stabilize the economy

Sarwat Jahan, Ahmed Saber Mahmud, and Chris Papageorgiou

D
URING the Great Depression of the 1930s, exist- • Aggregate demand is influenced by many economic deci-
ing economic theory was unable either to explain sions—public and private. Private sector decisions can some-
the causes of the severe worldwide economic col- times lead to adverse macroeconomic outcomes, such as
lapse or to provide an adequate public policy so- reduction in consumer spending during a recession. These
lution to jump-start production and employment.­ market failures sometimes call for active policies by the gov-
British economist John Maynard Keynes spearheaded a ernment, such as a fiscal stimulus package (explained below).
revolution in economic thinking that overturned the then- Therefore, Keynesian economics supports a mixed economy
prevailing idea that free markets would automatically provide guided mainly by the private sector but partly operated by
full employment—that is, that everyone who wanted a job the government.­
would have one as long as workers were flexible in their wage • Prices, and especially wages, respond slowly to changes
demands (see box). The main plank of Keynes’s theory, which in supply and demand, resulting in periodic shortages and
has come to bear his name, is the assertion that aggregate surpluses, especially of labor.­
demand—measured as the sum of spending by households,
businesses, and the government—is the most important Keynes the master
driving force in an economy. Keynes further asserted that
Keynesian economics gets its name, theories, and prin-
free markets have no self-balancing mechanisms that lead to
ciples from British economist John Maynard Keynes
full employment. Keynesian economists justify government
(1883–1946), who is regarded as the founder of modern
intervention through public policies that aim to achieve full
macroeconomics. His most famous work, The General
employment and price stability.­
Theory of Employment, Interest and Money, was pub-
The revolutionary idea lished in 1936. But its 1930 precursor, A Treatise on
Money, is often regarded as more important to econom-
Keynes argued that inadequate overall demand could lead
ic thought. Until then economics analyzed only static
to prolonged periods of high unemployment. An economy’s
conditions—essentially doing detailed examination of a
output of goods and services is the sum of four components:
snapshot of a rapidly moving process. Keynes, in Trea-
consumption, investment, government purchases, and net
tise, created a dynamic approach that converted eco-
exports (the difference between what a country sells to and
nomics into a study of the flow of incomes and expen-
buys from foreign countries). Any increase in demand has to
ditures. He opened up new vistas for economic analysis.­
come from one of these four components. But during a reces-
In The Economic Consequences of the Peace in 1919,
sion, strong forces often dampen demand as spending goes
Keynes predicted that the crushing conditions the
down. For example, during economic downturns uncertainty
Versailles peace treaty placed on Germany to end World
often erodes consumer confidence, causing them to reduce
War I would lead to another European war.­
their spending, especially on discretionary purchases like He remembered the lessons from Versailles and from
a house or a car. This reduction in spending by consumers the Great Depression, when he led the British delegation
can result in less investment spending by businesses, as firms at the 1944 Bretton Woods conference—which set down
respond to weakened demand for their products. This puts rules to ensure the stability of the international financial
the task of increasing output on the shoulders of the govern- system and facilitated the rebuilding of nations devastated
ment. According to Keynesian economics, state intervention by World War II. Along with U.S. Treasury official Harry
is necessary to moderate the booms and busts in economic Dexter White, Keynes is considered the intellectual found-
activity, otherwise known as the business cycle.­ ing father of the International Monetary Fund and the
There are three principal tenets in the Keynesian descrip- World Bank, which were created at Bretton Woods.­
tion of how the economy works:

Finance & Development September 2014   53

 •  Changes in aggregate demand, whether anticipated or ness cycle with fiscal policy and argued that judicious use
unanticipated, have their greatest short-run effect on real of monetary policy (essentially controlling the supply of
output and employment, not on prices. Keynesians believe money to affect interest rates) could alleviate the crisis (see
that, because prices are somewhat rigid, fluctuations in any “What Is Monetarism?” in the March 2014 F&D). Members
component of spending—consumption, investment, or gov- of the monetarist school also maintained that money can
ernment expenditures—cause output to change. If govern-
ment spending increases, for example, and all other spending
components remain constant, then output will increase. Keynesian economics dominated
Keynesian models of economic activity also include a mul-
tiplier effect; that is, output changes by some multiple of the economic theory and policy after
increase or decrease in spending that caused the change. If
the fiscal multiplier is greater than one, then a one dollar
World War II until the 1970s.
increase in government spending would result in an increase
in output greater than one dollar.­ have an effect on output in the short run but believed that
in the long run, expansionary monetary policy leads to
Stabilizing the economy inflation only. Keynesian economists largely adopted these
No policy prescriptions follow from these three tenets alone. critiques, adding to the original theory a better integration
What distinguishes Keynesians from other economists is of the short and the long run and an understanding of the
their belief in activist policies to reduce the amplitude of the long-run neutrality of money—the idea that a change in the
business cycle, which they rank among the most important of stock of money affects only nominal variables in the econ-
all economic problems.­ omy, such as prices and wages, and has no effect on real
Rather than seeing unbalanced government budgets as variables, like employment and output.­
wrong, Keynes advocated so-called countercyclical fiscal Both Keynesians and monetarists came under scrutiny
policies that act against the direction of the business cycle. with the rise of the new classical school during the mid-
For example, Keynesian economists would advocate defi- 1970s. The new classical school asserted that policymakers
cit spending on labor-intensive infrastructure projects to are ineffective because individual market participants can
stimulate employment and stabilize wages during economic anticipate the changes from a policy and act in advance to
downturns. They would raise taxes to cool the economy counteract them. A new generation of Keynesians that arose
and prevent inflation when there is abundant demand-side in the 1970s and 1980s argued that even though individu-
growth. Monetary policy could also be used to stimulate the als can anticipate correctly, aggregate markets may not clear
economy—for example, by reducing interest rates to encour- instantaneously; therefore, fiscal policy can still be effective
age investment. The exception occurs during a liquidity trap, in the short run.­
when increases in the money stock fail to lower interest rates The global financial crisis of 2007–08 caused a resurgence
and, therefore, do not boost output and employment.­ in Keynesian thought. It was the theoretical underpinnings
Keynes argued that governments should solve problems in of economic policies in response to the crisis by many gov-
the short run rather than wait for market forces to fix things ernments, including in the United States and the United
over the long run, because, as he wrote, “In the long run, we Kingdom. As the global recession was unfurling in late 2008,
are all dead.” This does not mean that Keynesians advocate Harvard professor N. Gregory Mankiw wrote in the New
adjusting policies every few months to keep the economy at York Times, “If you were going to turn to only one econo-
full employment. In fact, they believe that governments can- mist to understand the problems facing the economy, there
not know enough to fine-tune successfully.­ is little doubt that the economist would be John Maynard
Keynes. Although Keynes died more than a half-century ago,
Keynesianism evolves his diagnosis of recessions and depressions remains the foun-
Even though his ideas were widely accepted while Keynes dation of modern macroeconomics. Keynes wrote, ‘Practical
was alive, they were also scrutinized and contested by sev- men, who believe themselves to be quite exempt from any
eral contemporary thinkers. Particularly noteworthy were his intellectual influence, are usually the slave of some defunct
arguments with the Austrian School of Economics, whose economist.’ In 2008, no defunct economist is more promi-
adherents believed that recessions and booms are a part of nent than Keynes himself.”
the natural order and that government intervention only But the 2007–08 crisis also showed that Keynesian the-
worsens the recovery process.­ ory had to better include the role of the financial system.
Keynesian economics dominated economic theory and Keynesian economists are rectifying that omission by inte-
policy after World War II until the 1970s, when many
advanced economies suffered both inflation and slow
grating the real and financial sectors of the economy.­ ■
growth, a condition dubbed “stagflation.” Keynesian the- Sarwat Jahan is an Economist and Chris Papageorgiou is a
ory’s popularity waned then because it had no appropri- Deputy Division Chief in the IMF’s Strategy and Policy Review
ate policy response for stagflation. Monetarist economists Department. Ahmed Saber Mahmud is the Associate Director
doubted the ability of governments to regulate the busi- of Applied Economics at Johns Hopkins University.­

54   Finance & Development September 2014

Keynesian Economics
• Keynesian economics gets its name, theories,
and principles from British economist John
Maynard Keynes (1883–1946), who is
regarded as the founder of modern
macroeconomics.
• His most famous work, The General Theory of
Employment, Interest and Money, was
published in 1936.
• Keynesian economists justify government
intervention through public policies that aim to
achieve full employment and price stability.
Objectives:
• Avoid inflation
• Government involved
• Govt. Crisis support by other country
• Avoid inflation (Example)-Aircel, TATA Dokoma,
Vodofone, Virgin… etc.
• Reliance Infrastructure
• Mumbai Metro
• Reliance Roads
• Reliance Power
• Reliance Capital
• Reliance Naval and Engineering
• Reliance Defence
• Reliance Entertainment
• Kokilaben Dhirubhai Ambani Hospital
• Reliance Health Insurance Limited
• Bombay Suburban Electric Supply (BSES)
• Toll Roads
• Asset management, mutual funds, life insurance,
general insurance and commercial finance
• BIG cinema Home Entertainment
• Jio digital
• International School
• Petro-chemical Universities
• Reliance Trends
• Reliance fresh-Super market
• Reliance mall
• Reliance wear
• Reliance jewel
• Government Involved
• Tax
 Direct tax
1. Income tax
2. Wealth tax
3. Property tax
 In-direct tax
1. Sales tax
2. Service tax
3. Excise duty
4. Costumes duty & octroi
• Govt crisis support by other country
 India's developmental assistance to six neighbouring countries in South Asia over
the last four fiscal years amounted to over Rs 21,100 crore, the government
today informed the Rajya Sabha.
 India extended developmental assistance to six neighbouring countries --
Afghanistan, Bangladesh, Bhutan, Maldives, Nepal and Sri Lanka, according to
Minister of State for External Affairs V K Singh's written reply to a question.
 The total aid to Afghanistan from 2014-15 to 2017-18 was Rs 2,232.94 crore, to
Bangladesh it was Rs 514.13 crore, and to Bhutan it was Rs 15,680.97 crore.
 The developmental assistance to Maldives during the same period was Rs 270.39
crore, to Nepal it was Rs 1,322.54 crore, and to Sri Lanka it was Rs 1,080.55 crore.

The total developmental assistance to the six countries in the four years
amounted to Rs 21,101.52 crore.

Read more at:

https://economictimes.indiatimes.com/news/politics-and-nation/indias-aid-to-6-
neighbouring-nations-totalled-over-rs-21100-crore-in-4-
years/articleshow/65341395.cms?utm_source=contentofinterest&utm_medium
=text&utm_campaign=cppst
 Keynesian 4 components
• An economy’s output of goods and services is
the sum of four components:
1.Consumption,
2. Investment,
3. Government purchases, and
4. Net exports (the difference between what a
country sells to and buys from foreign
countries).
Aggregate demand is influenced by many
economic decisions— public and private.

• Private sector decisions can sometimes lead to

adverse macroeconomic outcomes, such as
reduction in consumer spending during a
recession.
• Keynesian economics supports a mixed
economy guided mainly by the private sector
but partly operated by the government.
Prices, and especially wages, respond
slowly to changes in supply and demand

• Resulting in periodic shortages and surpluses,

especially of labour.
Changes in aggregate demand, whether
anticipated or unanticipated, have their
greatest short-run effect on real output
and employment, not on prices

• Keynesians believe that, because prices are

somewhat rigid, fluctuations in any component of
spending—consumption, investment, or
government expenditures—cause output to
change.
• If government spending increases, for example,
and all other spending components remain
constant, then output will increase.
• Keynesian economics dominated economic
theory and policy after World War II until the
1970s.
• Not Just an account
By Vinod Rai
(Former Auditor general of India)
 Head lines: (THE HINDU, Dt:28/01/2020)
“Govt. sweetens Air India offer; Puts 100% stake on
the table”……. Against of Keynesian Economics
Why? Economics for Engineers
 Economics
• Economics is on the one side a study of
wealth; and on the other and more important
side, a part of the study of man.
-Adam smith [Father of economics]
 Industrial Economics
• Industries
• HR
• TRAINING
Administration • PURCHASE
• FINANCE

• STORES
• MACHINES
Production • WORKERS
• FINISHED GOODS STORES
• DESPATCH [Inventory]
Demand and Supply
 Demand
• Total quality customers are willing and able to
buy/Purchase the goods.
• Demand function is a behavior function for
consumers.
 Types of Demand
• Direct demand
Consumers goods [FMCG]
• Derived demand
Demand for steel is derived from the
demand for final goods [ Automobiles field]

Goods and services that satisfy consumer

desires.
Determinants of Demand
Taste and preferences
Income of the consumer
Advertising
Price of the goods
 Law of Demand

Price of the goods Demand of the goods

 Flipkart offers-Big million sale

 Amazon offers
 Supply
• Supply function is a behavior function for
producers.
• How many units of goods particulars sellers
willing to sell at particular price.
 Law of Supply

Price of the goods Supply of the goods

 Example
• Petrol & Diesel (Presently)

• A/C during summer

 Assessment Methodology
Cycle Test 1=25
Cycle Test 2=25
Assignment= 20
Endsem=30
 Students submit the answer script and
assignment to common mail.
• File Name Format
Roll no.-Name-July 2021
 Forecasting
Definition:
• Estimation of future demand for a product/
particular product/ product could be anything.
• Trial and Error based approach
• Error is minimum
• Scientific technique for future prediction
• Logical data interpretation
• Data analysis
 Types of Forecasting methods

• Types:
1. Simple average method
2. Increase or Decrease method
3. Weighted average method
4. Exponential smoothing method
 Simple average method
• Example:
Year Tea sales/Ton
2004 25
2005 32
2006 24
2007 28
2008 26
2009 27
2010 ?
Simple average= 25+32+24+28+26+27/6 (no.of
data's)
F= 27
F= Forecasting
 2. Increase/ Decrease Method
• Data level/Trend
Year Tea sales/Ton
2004 25 Decrease
2005 32 Increase
2006 24 Decrease
2007 28 Increase
2008 26 Decrease
2009 27 Increase
2010 ? ???
F= 26+27/2 = 26.5
 3. Weighted average method
• Taking a recent years data's
• Gives a weighted values
Example:
Taking last 3 years data's
Year Tea sales/Ton
2007 28
2008 26
2009 27
2010 ?
• 2007 gives weighted for 1
• 2008 gives weighted for 2
• 2009 gives weighted for 3
F= (1X28)+(2X26)+(3X27)/ 6 (Total allotted
weights)
= (28+52+81)/6
= 26.833
 4. Exponential smoothing
• Like Reverse engineering process
• Ft+1= ɸ Dt + (1-ɸ)Ft
F= Forecast
D= Demand
ɸ= Smoothing constant (0 to 1)
t= Time period
Dt= Demand of period ‘t’
• F7= ɸD6 + (1-ɸ)F6
• F6= ɸD5 + (1-ɸ)F5 …..Proceeding further
……. …….
……. …….

• F2= ɸD1 + (1-ɸ)F1

• F1= Simple average value=27
• ɸ= 0.2 (Let assume)
D1= 25
D2= 32
D3= 24
D4= 28
D5= 26
D6= 27
• F2= ɸD1+ (1-0.2) F1
• F2= 0.2x25+ (1-0.2)x27
= 26.6
Similarly,
F3=27.68
F4=26.94
F5=27.15
F6=26.92
F7=26.94
Competitive nature of
the Firms
 India and globalization

• The wake of globalization was first felt in

the 1990s in India when the then finance
minister, Dr Manmohan Singh initiated the
economic liberalization plan.
 Production Cost of Pepsi/Coke
• The actual raw material and labour cost won't be
more than Re 1.50 per bottle.
• But then the licensee manufacturer has to pay a
substantial amount as license fee. Then comes
the bottle, caps and other production costs like
power and fuel, depreciation on machinery etc.
• The marketing costs are actually much more than
production cost, given that huge amounts are
spent through celebrity ads, sales promotion etc.
 Competitive firms [Some Examples]
Indian MNC
• Kalimark Bovonto Pepsi/Coke
• DMART/Kannan Dept. Walmart
• Westside (Tata)/Raymonds Johnplayer (ITC)
• Jaguar Land Rover (Tata) Rolls-Royce
• TVS/Bajaj Honda
• CavinKare Hindustan Unilever
• Infosys/HCL/CTS/TCS Google/Microsoft/Oracle
• Onida/BPL LG/Samsung/Sony
 Global competiitve
• Jamnagar refinery is the world's largest oil refinery
with an aggregate capacity of 1.24 million barrels
per day (bpd).
• The refinery complex is located at Jamnagar in
Gujarat, India. It is owned and operated
by Reliance Industries.
• Indian Railway…. Monopoly.
• Employees… More than 13 Lakhs
 Eligibility Criteria for grant of
Maharatna status
• Listed on Indian stock exchange with minimum
prescribed public shareholding under SEBI regulations.
• Average annual turnover of more than Rs. 25,000
crore, during the last 3 years.
• Average annual net worth of more than Rs. 15,000
crore, during the last 3 years.
• Average annual net profit after tax of more than Rs.
5,000 crore, during the last 3 years.
• Should have significant global presence/international
operations.
 Criteria for grant of Navratna status
• Net profit to net worth,
• Manpower cost to total cost of
production/services,
• Profit before depreciation, interest and taxes to
capital employed,
• Profit before interest and taxes to turnover,
• Earning per share and
• Inter-sectoral performance.
Criteria for grant of Miniratna status

• The CPSEs [Central Public Sector Enterprises]

which have made profits in the last three years
continuously and have positive net worth are
eligible to be considered for grant of Miniratna
status.
 Types of Enterprises
• Small-Scale Industries:
These are the industrial undertakings
having fixed investment in plant and machinery,
whether held on ownership basis or lease basis
or hire purchase basis not exceeding Rs. 1 crore.
• A medium enterprise is an enterprise where
the investment in plant and machinery is more
than Rs. 5 crore but does not exceed Rs. 10
crore.
• Industries which requires huge infrastructure
and manpower with an influx of capital assets
are Large Scale Industries.
• In India, large-scale industries are the ones
with a fixed asset of more than one hundred
million rupees or Rs. 10 crores.
 Closed PSUC in India
• Tungabhadra Steel Products
• STCL Ltd (Formerly Spice Trading Corporation of India)
• Central Inland Water Transport Corporation
• Bharat Wagons and Engineering
• Bharat Jute
• CREDA-HPCL Biofuels
• Hindustan Cables
• Hindustan Organic Chemicals (nine out of 14 plants to be closed)
• Hindustan Vegetable Oil Corporation
• HMT Bearings
• HMT Chinar Watches
• HMT Watches
• Indian Oil-CREDA Biofuels
• National Jute Manufactures Corporation
• Triveni Structurals
• Tyre Corporation of India
• Hindustan Photo Films Manufacturing
• KGF
• BSNL (to be……)
 Factors & Factors Affecting Global
Competitiveness
• Physical infrastructure plays a critical role in improving the global competitiveness of a
country. This will lead to the smoother movement of people, products, and services,
facilitating faster delivery of goods and services.
• The business environment should be as such that it improves coordination among
public-sector agencies. The best methods include providing support and incentives for
R&D activities, HRD and education, encouraging innovativeness and creativity,
facilitating the improvement of industrial blocks, and productivity enhancements of
SMEs.
• High total factor productivity (TFP) is a boon for economic growth. It shows the synergy
and efficiency of both capital and HR utilization and promotes national competitiveness.
• Productivity campaigns are important because they promote public-awareness and
provide mechanisms to use the productivity tools and techniques.
• Intensifying R&D activities that contribute to creativity, innovation, and indigenous
technological development is also an important factor.
• Improving the capacities of SMEs to become increasingly productive suppliers and
exporters makes strategic sense.
• Tax
 Cost and Revenue
• Cost
Cost is the amount, measured in money or
cash expended or other property transfer capital
stock, issued serviced performed or liability
incurred, in consideration of goods or services
received or to be received.
- American institute of certified Accountants
Cost may be defined as the total of all
expenses incurred, whether paid or outstanding, in
the manufacture and sale of a product.
 Elements of cost

Materials Labour Expenses

Direct Indirect Direct Indirect

Direct Indirect

Over heads

Production overheads Administration overheads Selling & distribution overheads

• Direct material cost
Direct material cost is material that can be directly
identified with each unit of finish product.
Example:
Iron rod to bold…………. Iron
Lime to chalk…………….. Lime
• Indirect material cost
Materials used for the product other than the direct
materials.
Example:
Lubrication for bold
Chalk pattern box
Labour cost
The labour cost is the cost of remuneration [wages, salaries,
bonus..etc] of the employees of an undertaking.
-Institute of cost and management Accounts, London.
 Direct labour cost:
The cost of labour directly engaged in production operations.
Example:
Workmen engaged in motor assembling
 Indirect labour cost:
The cost/remuneration paid for labour engaged to help the
production operations.
Example:
Watchmen, Sweepers [Cleaning of shop floor]
• Direct expenses:
These are the expenses which can be directly
identified with a unit of output, job, process or operation.
Example:
Cost of patterns, designs or plans for a job
• Indirect expenses:
Indirect expenses are expenses other than indirect
materials and indirect labour, which can not be directly
identified with units of outputs, jobs, process of operation.
Example:
Power supply, Lighting, Fans, Depreciation, Bank
charges, Advertisements.
 Cost behaviors
• Fixed cost
• Variable cost
• Marginal cost

 Fixed cost
The cost tends to be unaffected with the volume
of output.
Fixed cost depends upon the passage of time and
does not vary directly with the volume of output.
Example:
Rent of factory
Insurance of factory
Variable cost
Variable cost tends to vary directly with the
volume of output.
It varies almost in direct proportion to the
volume of production.
If prodcution increases, variable cost will be
increases.
Example:
Direct material cost
Direct labour cost
Marginal cost
Marginal cost= Total cost – Fixed cost

 Total cost= Fixed cost+ Variable cost

Revenues:
The sales of goods/ Services.
 Break-Even Analysis
• Break-Even analysis implies that the total revenue equals
the total cost at some point in the operations.
• Break-Even analysis is concerned with finding the point at
which revenues and cost agree exactly. It can be carried
out algebraically or graphically.
Break-Even Point
• Break-Even point is, therefore, the volume of output at
which neither a profit is made nor a loss is incurred.
• Break-Even point is a point where the total sales are equal
to total cost.
 Break-Even Chart
• Break-Even chart is a graphical representation of the
relationship between costs and revenue at a given time.
Total Sales (S)

Total cost (TC)

B
Break-even sales
Variable cost (VC)
Sales

Loss
Fixed cost (FC)

Break Even Point (Q)

Quantity of Production
 It is a graphic device to determine the break-even
point and profit potential under varying conditions of
output and costs.
Total cost= Fixed cost + Variable cost
Variable cost (VC) = v*Q
Where, v=Variable cost/unit
Q= Volume of production
Total sales (S)= s*Q
Where, s= Selling price/unit
• The intersection point of the total sales line and the total
cost line is called as the break-even point.
• At the intersection point (B), the total cost is equal to the
total revenue.
• For any production quantity which is less than the break-
even quantity, the total cost is more than the total
revenue. Hence, the firm will be making loss.

• For any production quantity which is more than the break-

even quantity, the total revenue will be more than the
total cost. Hence, the firm will be making profit.

Profit= Total sales- (Fixed cost + Variable cost)

 National Income
• Aim of National Income
 To ensure constant growth and equitable distribution of national
resources.
 To ensure that the economic activities are carried out in such a way
that the majority of people are benefitted and the economic
growth of the nation is ensured.
 The measurement of the size of the economy and level of country's
economic performance.
 Full employment.
 Price stability.
 A high, but sustainable, rate of economic growth.
 Keeping the balance of payments in equilibrium.
 Low inflation
 History of National Income

• A.D. 1867-68 Mr.Thathabjai Nouroji started

• A.D. 1931-32 Prof. V.K.R.V. Rao…. Using scientific
methods
• A.D. 1949 National Income Group (NIG)
• First report of NIG-1954 by Prof. Mahilalophis
• A.D.1955 on words- Central Statistical
Organisation (CSO), New Delhi.
 Definition of National Income (NI)
• National Income refers to the money value of all the
goods and services produced in a country during a
financial year.
• In other words, the final outcome of all the economic
activities of the nation during a period of one year,
valued in terms of money is called as a National
income.
• The total amount of income accruing to a country
from economic activities in a financial year's time is
known as national income. It includes payments
made to all resources in the form of wages, interest,
rent and profits. This is the true net annual income or
revenue of the country or national dividend. .
 Financial Year
• April 1 to March 31
 Components of NI

• Personal consumption expenditures.

• Investment.
• Net exports.
• Government expenditure
 NI formula
• National Income = C (household consumption) + G
(government expenditure) + I (investment expense)
+ NX (net exports).

• The formula for calculating net national income is:

NNI = C + I + G + NX + NFF - IT - D.

Where: C = Consumption, I = Investments,

G = Government spending, NX = Net exports
(calculated by subtracting imports from exports),
NFF = Net foreign factor income, IT = Indirect taxes,
D = Depreciation.
 GDP & GNP
• Gross Domestic Product (GDP),
Gross National Product (GNP), and National
Income measures attempt to measure how
much economic activity took place during a
specified amount of time (usually a year).
• GNP measures the market value of all final
goods and services produced by a country's
citizens or residents.
 Different constituents of GDP

• Wages and salaries

• Rent
• Interest
• Undistributed profits
• Mixed-income
• Direct taxes
• Dividend
• Depreciation
 Factors affecting NI
• The quantity and quality of a country's resources
exert perhaps the most important influences on
its national income.
• Example
Fertile soil, ready sources of power, easily
worked mineral deposits, a favourable climate,
navigable rivers, etc.
 Components of National Income

• Gross Domestic Product (GDP)

• Net Domestic Product (NDP)
• Gross National Product (GNP)
• Net National Product (NNP)
 GDP
• The market value of the output of final goods and
services produced in the domestic territory of a
country during an accounting year.
• Gross domestic product (GDP) is one of the most
common indicators used to track the health of a
nation's economy. It represents the total dollar value
of all goods and services produced over a specific
time period, often referred to as the size of the
economy
• There are three different ways to measure GDP/NI
1.Product Method, 2.Income Method and
3.Expenditure Method.
These three methods of calculating GDP yield the same
result because National Product = National Income =
National Expenditure.
• The Product Method:
• In this method, the value of all goods and services
produced in different industries during the year is
added up. This is also known as the Value Added
Method to GDP or GDI at Factor Cost by Industry of
Origin.
• The following items are included in India in this:
agriculture and allied services; mining;
manufacturing, construction, electricity, gas and
water supply; transport, communication and trade;
banking and insurance, real estates and ownership of
dwellings and business services; and public
administration and defence and other services or
government services. In other words, it is the sum of
Gross Value Added.
• The Income Method:
• The people of a country who produce GDP
during a year receive incomes from their work.
Thus GDP by income method is the sum of all
factor incomes: Wages and Salaries
(compensation of employees) + Rent + Interest +
Profit.
• Expenditure Method:
• This method focuses on goods and services
produced expenditure within the country during
one year.
• Net Domestic Product (NDP)
• NDP is the value of net output of the economy
during the year.
• Gross National Product (GNP)
• GNP is the total measure of the flow of goods
and services at market value resulting from
current production during a year in a country,
including net income from abroad.
• Net National Product (NNP)
• GNP includes the value of total output of
consumption goods and investment goods. But
the process of production uses up a certain
amount of fixed capital. Some fixed equipment
wears out, its other components are damaged or
destroyed, and still others are rendered obsolete
through technological changes.
• NNP= GNP-Depreciation.
 Stock Exchanges in India
• It is a place where shares of pubic listed
companies are traded. A stock exchange
facilitates stock brokers to trade
company stocks and other securities. A stock may
be bought or sold only if it is listed on an
exchange.
• National Stock Exchange (NSE)-Worli, Mumbai.
• Bombay Stock Exchange (BSE)- Thalal street,
Mumbai. [Asia's oldest stock exchange]
• Delhi Stock Exchange (DSE)-Delhi.
• Madras Stock Exchange (MSE)- Madras.
Bulls Vs Bear in Stock Market
Economic Milestone: Stock Market
Scam (1992)
 Biggest Financial Crimes in Indian
Stock Exchange
• Harshad Mehta was an Indian stockbroker, well
known for his wealth and for having been charged
with numerous financial crimes that took place in
the 1992 securities scam.
• Mehta was convicted by the Bombay High
Court and Supreme Court of India for his part in a
financial scandal valued at 5000 Crores which took
place on the Bombay Stock Exchange (BSE).
• The scandal exposed the loopholes in the Indian
banking system, Bombay Stock Exchange
(BSE) transaction system and SEBI further introduced
new rules to cover those loopholes. He was tried for
9 years, until he died in late 2001.
The Satyam scandal: How India’s
biggest corporate fraud unfolded
• A special court under India’s Central Bureau of
Investigation (CBI) on April 10 held the founders and
former officials of outsourcing firm, Satyam
Computer Services, guilty in an accounting scam
worth Rs7,000 crore ($1.1 billion). B Ramalinga Raju,
the company’s former chairman, has been sentenced
to seven years in jail.
• The case, which is also called the Enron of India,
dates back to 2009. Six years ago, Raju wrote a letter
to the Securities and Exchange Board of India (SEBI)
and his company’s shareholders, admitting that he
had manipulated the company’s earnings, and fooled
investors. Nearly $1 billion—or 94% of the cash—on
the books was fictitious.
 Unit.2.International Trade
• Meaning:
International trade is the exchange of capital,
goods, and services across international borders or
territories. In most countries, such trade represents
a significant share of gross domestic product (GDP).
International Trade is important because all
countries have limited resources to respond to their
people's needs. So countries trade with one another
to complete each other's needs. It allows countries,
communities and individuals to specialize in
something and become increasingly productive.
• Benefits:
• Increased revenues
• Decreased competition
• Longer product lifespan
• Easier cash-flow management
• Better risk management
• Benefiting from currency exchange
• Access to export financing
• Disposal of surplus goods
• International Trade is important to the world economy,
then, both because it allows us to get things we can't
produce at home and because it allows each country to
make what it is best at. This allows more people to have
more goods and services than would otherwise be possible.
• Foreign trade creates an opportunity for the
produces to reach beyond the domestic markets.
Producers can sell their produce not only in
markets located within the country but can also
compete in markets located in other countries of
the world.
• Comparative Advantage
• Economies Of Scale
• Competition
• Transfer Of Technology
• More Job Creation
• Examples:
• Natural Resources. The exchange of natural
resources such as water, wood or iron ore.
Materials. The exchange of materials such as
wood products or steel.
• Components & Parts.
• Finished Goods.
• Consumer Services.
• Business Services.
• Ecommerce.
 Types of International Trade
• Types of Foreign Trade – The two types of Foreign
Trade are:
• Bilateral trade: This is a trade agreement in which
two countries exchange goods and services.
Example: South Korea-China
• Multilateral trade: This is the type of
international trade where a country trade with
two or more countries.
• Division of Foreign Trade
• Import Trade: Import trade refers to purchase of
goods by one country from another country or inflow
of goods and services from foreign country to home
country.
• Export Trade: Export trade refers to the sale of goods
by one country to another country or outflow of
goods from home country to foreign country.
• Entrepot Trade: Entrepot trade is also known as Re-
export. It refers to purchase of goods from one
country and then selling them to another country
after some processing operations.
Example: Crude oil
 Basis of International Trade
• A country specializes in a specific commodity due to
mobility, productivity and other endowments of economic
resources.
• This stimulates a country to go for international trade.
The basis of international trade lies in the diversity of
economic resources in different countries.
• Geography (the climate, terrain, seaports, and natural
resources of a country)
Example: Meat-USA (Winter climate)
• Culture and Society (the accepted behaviours, customs,
and values of a society to include language, education,
religion, values, customs, and social relationships)
Example: Hindustan Unilever, Indian Tobacco Company
• Politics and Law (the type of government, the
stability of the government, and government
policies toward business; and anti-corruption and
anti-bribery laws, import and export regulations,
labor laws, intellectual property protection and
licensing, product safety, and consumer
protection)
Example: Privatization-Presently-Train, Army etc..
• Economy (the types of industries and jobs in the
country and the stability of the country’s money
supply)
• Reasons for International Trade/Foreign Trade
• Uneven distribution of natural resources:
• Expansion of market for products: Foreign trade
is necessary as it helps to widen the market for
goods produced.
• Difference in taste
• Difference in technology
• Difference in skills
• Difference in climatic condition
• Desire to improve the standard of living
• Difference in efficient use of natural resources
• India stands third in purchasing power parity in
the world.
• World Trade Center Chennai
• The World Trade Center Chennai is a commercial
center under construction
at Perungudi in Chennai, India. It is expected to be
operational in 2020. The centre is a member of
the international World Trade Centers
Association (WTCA).
• World Trade Center Headquarters
• New York City, New York, U.S.
 India’s Top 10 Exports

• Mineral fuels including oil: US$48.3 billion (14.9% of total

exports)
• Gems, precious metals: $40.1 billion (12.4%)
• Machinery including computers: $20.4 billion (6.3%)
• Vehicles: $18.2 billion (5.6%)
• Organic chemicals: $17.7 billion (5.5%)
• Pharmaceuticals: $14.3 billion (4.4%)
• Electrical machinery, equipment: $11.8 billion (3.6%)
• Iron, steel: $10 billion (3.1%)
• Cotton: $8.1 billion (2.5%)
• Clothing, accessories (not knit or crochet): $8.1 billion
(2.5%)
 India’s Top 8 imports

• Oil.
• Precious stones.
• Electronics.
• Heavy machinery.
• Organic chemicals.
• Plastics.
• Animal and vegetable oil.
• Iron and Steel.
 Largest trading Imports partners

Rank Country&Region Imports

1 China 68.06

2 United States 25.7

3 United Arab Emirates 19.45

4 Saudi Arabia 20.32

• India's top 3 imports: Petroleum crude, Gold
& Silver, Electronic Goods.
• India's top 3 exports: Petroleum products,
Gems & Jewellery, Pharma products.
• India is the 17th largest export economy in the world and the 45th
most complex economy according to the Economic Complexity
Index (ECI).
• The top exports of India are
• Refined Petroleum, Diamonds,
• Packaged Medicaments,
• Jewellery
• Rice.
• India top imports are
• Crude Petroleum
• Gold, Diamonds
• Coal Briquettes
• Petroleum Gas
• The top export destinations of India are
• The United States
• The United Arab Emirates
• China
• Hong Kong
• Germany.
• The top import origins are
• China
• The United States
• The United Arab Emirates
• Switzerland
• Saudi Arabia
 Largest Investors of India / Foreign
Direct Investment (FDI)
• Singapore
• Mauritius
• The US
• Netherlands
• Japan
 Afghanistan

• Connectivity between Arab countries to US

and UK
• No stable government
• Religious based country
 Foreign Trade and Economic growth
• Definition:
Foreign trade is exchange of capital, goods,
and services across international borders or
territories. In most countries, it represents a
significant share of gross domestic product (GDP).

Foreign trade is highly competitive. To

maintain and increase the demand for goods, the
exporting countries have to keep up the quality of
goods. Thus quality and standardised goods are
produced.
 Economic growth through Foreign
Trade
• Increasing GDP rate
• Economic growth
• Decreasing poverty
• Increasing employment
• Expanding the market and encouraging the
producers.
• Increasing purchasing to the consumers
• Domestic companies-Producing Foreign market
• Competitive advantage in Global Trade
• If the demand for home product is inelastic, the
terms of trade will be profitable to the home country.
 Features of Foreign Trade
• Change in the composition of exports
• Change in the composition of imports
• Direction of foreign trade
• Balance of trade
• Dependent trade
• Trade through sea routes
 Balance of Trade (BOT)
• BOT= Total value of exports- Total value of
imports
• A positive trade balance indicates a trade surplus
• Negative trade balance indicates a trade deficit.

• Value of Exports is the value of goods and

services that are sold to buyers in other
countries.
• Value of Imports is the value of goods and
services that are bought from sellers in other
countries.
• A positive balance occurs
when exports > imports and is referred to
as a trade surplus.
• A negative trade balance occurs
when exports < imports and is referred to
as a trade deficit
 Balance of Payment
• Balance Of Payment (BOP) is a statement which
records all the monetary transactions made
between residents of a country and the rest of
the world during any given period.
• This statement includes all the transactions made
by/to individuals, corporates and the
government and helps in monitoring the flow of
funds to develop the economy.
• The main objectives of economic policy are to
achieve sustainable high economic growth, full
employment, price stability and balance-of-
payments equilibrium.
 Disequilibrium in the Balance of
payments of a country
• Unfavourable Balance of Trade
• Cyclical Fluctuations of Price
• Burden of Payment of Foreign Debt
• Speedy Economic Development
• Inadequate Promotion of Exports
• BOP statement of a country indicates whether
the country has a surplus or a deficit of funds
i.e when a country’s export is more than its
import, its BOP is said to be in surplus. On the
other hand, BOP deficit indicates that a
country’s imports are more than its exports.
• BOP is a systematic record of all economic
transactions between one country and the
rest of the world.
• BOP includes all transactions, visible as well as
invisible.
 Types of BOP
1.The current account
2.The capital account
3.The financial account
BOP= Balance of current account + Balance of capital
account + Balance of financial account.
BOP

Current Account Capital Account Financial Account

(Goods & Service) (Asset) (Investments &
Intangibles)
 Current Account
• The current account is used to monitor the inflow
and outflow of goods and services between
countries.
• This account covers all the receipts and payments
made with respect to raw materials and
manufactured goods.
• It also includes receipts from engineering,
tourism, transportation, business services, stocks,
and royalties from patents and copyrights.
• When all the goods and services are combined,
together they make up to a country’s Balance Of
Trade (BOT).
 Capital Account
• All capital transactions between the countries are monitored
through the capital account.
• Capital transactions include the purchase and sale of assets
(non-financial) like land and properties.
• The capital account also includes the flow of taxes, purchase
and sale of fixed assets etc by migrants moving out/in to a
different country. The deficit or surplus in the current
account is managed through the finance from capital account
and vice versa.
• There are 3 major elements of capital account:
• Loans & borrowings
• Investments –Through NRIs
• Foreign exchange reserves – Foreign exchange reserves held
by the central bank of a country to monitor and control the
exchange rate does impact the capital account.
 Financial Account
• The flow of funds from and to foreign
countries through various investments in real
estates, business ventures, foreign direct
investments etc is monitored through the
financial account.
• This account measures the changes in the
foreign ownership of domestic assets and
domestic ownership of foreign assets.
 Importance of BOP
• A country’s BOP is vital for the following reasons:
• Shows the financial and economic status.
• Indicate to the country’s currency value is
appreciating or depreciating.
• It helps the Government to decide on fiscal and
trade policies.
• It helps to analyse and understand the economic
dealings of a country with other countries.
 Currents Trends in India
• All export and import-related activities are
governed by the Foreign Trade Policy (FTP).
• The Directorate General of Foreign Trade (DGFT)
is the agency of the Ministry of Commerce and
Industry of the Government of India responsible
for administering laws regarding foreign
trade and foreign investment in India.
[S.Jaishankar-Minister of External offers]
• It is aimed at enhancing the country's exports and
use trade expansion as an effective instrument
of economic growth and employment generation.
 Country has maximum foreign trade
with India
• US
• Bangladesh
• Nepal
• In India, Foreign trade helps the people to get
different varieties of goods both in quantities
terms and qualitative terms.
• Foreign trade helps a developing country
like India in its economic development.
 Types of Foreign Trade in India
• Export Trade
• Import Trade
• Entrepot Trade
India Import Trade with the following
Countries
• China
• US
• UAE
• Saudi Arabia
• Who is world's largest importer?
• Who is the world's largest exporter?
• India's Top Trading Partners
Bangladesh
Netherlands
Nepal
Belgium
Vietnam
Malaysia
Italy
Saudi Arabia
• India's top 3 imports:
Petroleum crude
Gold & Silver
Electronic Goods
India's top 3 exports:
Petroleum products
Gems & Jewellery
Pharma products
• What is difference between Indian tea and
foreign tea?
• What is difference between tea and dust tea?
 Barriers to International Trade

• A barrier to trade is a government-imposed

restraint on the flow of international goods or
services.
• International trade is carried out by both
businesses and governments

Example:Afghanistan--- Banned the Indian products

South Korea--- Trade with China only
Trade barriers are government-induced
restrictions on International Trade
• Tariffs
• Non-tariff barriers to trade
• Import licenses
• Export licenses
• Import quotas
• Subsidies
• Voluntary Export Restraints
• Local content requirements
• Embargo
• Currency devaluation
• Trade restriction
• Cultural Barriers-Language, belief system (Beef exports-First
Place)
• Technological Barriers
• National Security
• Domestic sellers
• Economic barriers- Govt. rules and policies
Goods and Service Tax-July 01, 2017
In India GST rate for various goods and services is
divided into four slabs: they are 5% GST, 12% GST, 18%
GST, & 28% GST.
Gold biscuits- 3%
Eatable biscuits- 18%
Australia GST– 10%
Singapore GST-7%
 Trade restrictions
• Tariff
It is a tax put on goods imported from abroad
and sometimes referred to as custom duties.
• Quota
It is a limit on the amount of goods that can be
imported.
• Embargoes
It is a government order which completely
prohibits trade with another country.
Example: Cuba [Communism]
 Restriction benefits of International
Trade
• To product domestic industries from foreign
goods [BPL, ONIDA]
• To promote new industries and R&D activities by
providing a domestic market
• To maintain favorable balance of payment
• To conserve foreign exchange reserves
• To protect the national economy and domestic
money flow
 Types of Trade barriers
• Export duty
• Import duty
• Transit duty- Tax imposed on a commodity
when it crosses the national frontier between
the originating country
 Export duty Issue
• GD Naidu
 World Trade Organization (WTO)

Definition:
• The World Trade Organization (WTO) is the only global
international organization dealing with the rules of trade
between nations.
• Its main function is to ensure that trade flows as
smoothly, predictably and freely as possible.
• Location: Geneva, Switzerland
• Head: Ngozi Okonjo-Iweala (Director-General)
• Established: 1 January 1995
• The WTO officially commenced on 1 January
1995 under the Marrakesh Agreement, signed
by 123 nations on 15 April 1994, replacing the
General Agreement on Tariffs and Trade
(GATT), which commenced in 1948. It is the
largest international economic organization in
the world.
• Total Members: 164
Functions/Key objectives of WTO:
• Administering WTO trade agreements
• Forum for trade negotiations
• Handling trade disputes
• Monitoring national trade policies
• Technical assistance and training for developing
countries
• Cooperation with other international
organizations
 Indian EXIM Policy
• Definition:
EXIM Policy is the export import policy of the
government that is announced every five years. This policy
consists of general provisions regarding exports and
imports, promotional measures, duty exemption schemes,
export promotion schemes, special economic zone
programs and other details for different sectors.
• Trade Policy is prepared and announced by the Central
Government (Ministry of Commerce).
• Export Import Policy also known as Exim Policy.
• Also known as Foreign Trade Policy
 Indian EXIM current Policy
• Trade Policy is prepared and announced by the Central
Government (Ministry of Commerce). India's Export
Import Policy also know as Foreign Trade Policy, in
general, aims at developing export potential, improving
export performance, encouraging foreign trade and
creating favourable balance of payments position.
• The Government of India advices the EXIM Policy of India
for a phase of 5 years under section 5 of the Foreign
Trade Development and Regulation Act, 1992.
• The EXIM Policy is renewed every year on the 31st of
March and the revisions, improvements and new
proposals become effective from 1 st April of every year.
 Objectives of EXIM Policy
• To establish the framework for globalization
• To promote the productivity, competitiveness of
Indian industry
• To generate new employment
• To provide quality consumer products at
reasonable prices
• The policy aims at developing export potential,
improving export performance, boosting foreign
trade and earning valuable foreign exchange.
 EXIM
• Export-Import (EXIM) Bank of India is the principal financial
institution set up in 1982 under the Export-Import Bank of India
Act 1981 for coordinating the working of institutions engaged in
financing export and import trade in India.
• Exim Policy, also known as the Foreign Trade Policy is announced
every 5 years by Ministry of Commerce and Industry, Government
of India. It is updated every year on the 31st of March and all the
amendments and improvements in the scheme are effective from
the 1st of April.
 An international exchange rate, also known as
a foreign exchange rate, is the price of one country's
currency in terms of another country's currency. Exchange
rates play a vital role in a country's level of trade, which is
critical to most every free market economy in the world.
• Definition:
The foreign exchange market (Forex, FX, or
currency market) is a global decentralized or over-the-
counter market for the trading of currencies.
This market determines foreign exchange rates for
every currency. It includes all aspects of buying, selling
and exchanging currencies at current or determined
prices.
Exchange rate:
An exchange rate is the value of one
nation's currency versus the currency of another
nation or economic zone. For example, how many INR
does it take to buy one USD? As of 31-08-2021, the
exchange rate is 73.26, meaning it takes INR 73.26 to
buy $ 1
 A currency is classified as strong when it is
worth more than another country's currency.
The dollar gets stronger when its exchange rate
rises relative to other currencies like the Chinese
yuan and the European Union’s euro. Thus,
exchange rates can affect foreign trade via
depreciation of currency, economic impact on
importers, impact on profit margins or price,
appreciation of local currency and the state of
the economy.
• Depreciation of Currency
When there is a depreciation of a local
currency relative to another, the country’s
exports become cheaper for foreign traders, and
thus improve the export competitiveness of that
nation.
A weaker domestic currency stimulates
exports and makes imports more expensive. On
the other hand, a strong domestic currency can
hamper exports and make imports cheaper.
• Appreciation/Strengthening of Currency
A strengthening dollar can create
trouble for U.S. companies that export a lot of
goods to other countries. As products are priced
in dollars, those exports become more
expensive for the foreign consumers and
businesses that have to pay for them in other
currencies. The value of the profits they make
on export sales falls when they convert overseas
profits back to dollars.
 The spot price is the current price in the
marketplace at which a given asset—such as a
security, commodity, or currency—can be bought or
sold for immediate delivery. In contrast to the spot
price, a futures price is an agreed upon price for
future delivery of the asset.
Forward pricing is a convention used by
mutual funds to price fund shares based on the end
of each day's net asset value (NAV). NAV computes
the total market value of the investments held by
the fund less fund liabilities and expenses
• Forward price is the price at which a seller
delivers an underlying asset, financial
derivative, or currency to the buyer of
a forward contract at a predetermined date.

• It is roughly equal to the spot price plus

associated carrying costs such as storage
costs, interest rates, etc.
Factors influencing Exchange rates
• Inflation.
• Interest rates.
• Speculation.
• Change in competitiveness.
• Relative strength of other currencies.
• Balance of payments.
• Government debt.
• Government intervention
 The effect of Exchange rates in
Foreign Trade
 A country with a high demand for its goods tends to
export more than it imports, increasing demand for its
currency trade.
 The exchange rate has an effect on the trade surplus (or
deficit), which in turn affects the exchange rate, and so
on.
 In general, however, a weaker
domestic currency stimulates makes exports and imports
more expensive. Conversely, a strong
domestic currency hampers exports and makes imports
cheaper.
 The Effect of Exchange rates in
Foreign Trade
1. BOP
2. Inflation
3. Interest rate…. Repo rate & Reverse Repo rate
4. Monetary Policy
5. Economic Strength
6. Resource Discovery
7. Capital Movements
8. Speculation
9. Market factor
10. Political Factor
• A weaker domestic currency stimulates
exports and makes imports more expensive.
Conversely, a strong
domestic currency hampers exports and
makes imports cheaper.
• The currency exchange rate is one of the
most important determinants of a country's
relative level of economic health.
• A higher-valued currency makes a country's
imports less expensive and its exports more
expensive in foreign markets.
• Increase in exchange rate in favour of
the business will result in more value or worth of
goods for their money.
• Decrease in exchange rate against the interests of
the business will require the business to spend more
money for the some value or worth of goods.
• The value of the dollar is both caused and reflected
by interest rates, and interest rates have much
to do with stock prices. Therefore, exchange rates
affect stock prices and can be used to make
predictions about the market.
• Types of Exchange rate
1. Floating exchange,
2. Fixed exchange,
3. Pegged float exchange
 Countries That Have Lower Currency
Value Than Indian Rupees
• 1 Indian Rupee = 349.78 Vietnamese Dong.
• 1 Indian Rupee = 2.40 Sri Lankan Rupee.
• 1 Indian Rupee = 211.34 Indonesian Rupiah.
• 1 Indian Rupee = 1.60 Nepalese Rupee.
• 1.00 Indian Rupee = 1 Bhutanese Ngultrum.
• 1 INR = 8.07 Costa Rica Colons.
• 1 INR = 84 Paraguay Guarani.
Vietnam
1 Indian Rupee = 349.78 Vietnamese Dong
Sri Lanka
1 Indian Rupee = 2.40 Sri Lankan Rupee
Indonesia
1 Indian Rupee = 211.34 Indonesian Rupiah
Paraguay
1 INR = 84 Guarani
https://triptaptoe.com/getaways/wp-content/uploads/2018/03/14087895662_da6c84829d_k-1200x900.jpg
UNIT-4
 Tools for hedging against Exchange
rate variations
• Definition:
A risk management strategy used in limiting or offsetting
probability of loss from fluctuations in the prices of
commodities, currencies, or securities. In effect, hedging is a
transfer of risk without buying insurance policies.
Hedging refers to a method of reducing the risk of loss caused
by price fluctuation.
Example:
Hedging is an insurance-like investment that protects
you from risks of any potential losses of your
finances. Hedging is similar to insurance as we take an
insurance cover to protect ourselves from one or the other loss.
For example, if we have an asset and we would like to protect it
from floods.
• Hedging Tools:
Hedging refers to strategies for minimizing the
impact of fluctuations in the exchange rate.
Forward, Futures and Currency options
Forward:
A forward is a made-to-measure agreement
between two parties to buy/sell a specified amount of a
currency at a specified rate on a particular date in the
future.
A currency forward, also known as
a forward contract, is an agreement that allows the
buyer to lock in an exchange rate the day on which the
agreement is signed for a transaction that will be
completed later. Currency forwards are traded over-
the-counter (they are not traded on a central
exchange).
Futures/Futures Contract:
A future contract is similar to the forward
contract but is more liquid because it is traded in an
organized exchange. i.e the futures market.
Depreciation of a currency can be hedged by selling
futures and appreciation can be hedged by buying
futures. Advantages of futures are that there is a
central market for futures which eliminates the
problem of double coincidence.
Currency Options:
A currency option is a contract giving the right, not
the obligation, to buy or sell a specific quantity of one
foreign currency in exchange for another at a fixed price,
called the Exercise price or strike price. Currency Options
are particularly suited as a hedging tool for contingent
cash flows, as is the case in bidding processes.
A currency option (also known as a forex option) is a
contract that gives the buyer the right, but not the
obligation, to buy or sell a certain currency at a specified
exchange rate on or before a specified date. For this right,
a premium is paid to the seller. Currency options are one
of the most common ways for corporations, individuals or
financial institutions to hedge against adverse movements
in exchange rates.
FEMA
 FEMA-Foreign Exchange Management
Act
• The Foreign Exchange Management Act,
1999 is an Act of the Parliament of India "to
consolidate and amend the law relating to
foreign exchange with the objective of
facilitating external trade and payments
and for promoting the orderly development
and maintenance of foreign exchange
market in India".
• Enacted by: Parliament of India
• Enacted in: 29 December 1999
• Implemented: 1st of June, 2000
• Ruling Party: BJP
• Finance Minister: Yashwant Sinha
• Objective:
The main objective of FEMA is to facilitate external
trade and payments and for promoting the orderly
development and maintenance of foreign exchange market in
India.
FEMA deals with provisions relating to procedures, formalities,
dealings, etc. of foreign exchange transactions in India.
 National central banks play an important role in the foreign
exchange markets. They try to control the money supply,
inflation, and/or interest rates and often have official or
unofficial target rates for their currencies. They can use
their often substantial foreign exchange reserves to stabilize
the market.
• Replaced FERA to FEMA Act 1999
• Facilitating external trade
• For promoting the orderly development and
maintenance of foreign exchange market in India
• To remove imbalance of payment
 Determination of Foreign Exchange
rate
• Foreign Exchange Rate Determination. Foreign Exchange
Rate is the amount of domestic currency that must be
paid in order to get a unit of foreign currency. According
to Purchasing Power Parity theory, the foreign exchange
rate is determined by the relative purchasing powers of
the two currencies.
• The exchange rate of any currency is the number of units
of that currency which is exchanged for 1 unit of the
other currency.
• Rs 63 to get 1 $ in return. This exchange rate is
determined by the market forces of demand and supply.
• The value of money is determined by the demand for it,
just like the value of goods and services. When the
demand for Treasuries is high, the value of the U.S.
dollar rises.
• The demand and supply of foreign currency in
the economy is determined by prices prevailing in the
domestic and foreign market for the respective goods,
commodities and services, the price elasticity of goods,
and services, and also the movement of capital from one
market to the another.
1. Differentials in Inflation
2. Differentials in Interest Rates
3. Public Debt.
4. Terms of Trade
5. Political Stability and Economic Performance
 Forecasting Exchange Rate
Determination
• Objective:
Hedging Decisions
Short-term Financing Decisions
Short-term Investment Decisions
Long-term Financing Decisions
Earning Assessment
Capital Budgeting Decisions
• Hedging Decision
-Whether a firm hedges may be determined by its
forecast of foreign currency values.
• Short-term Financing Decision
- When large corporations borrow, they have
access to several different currencies.
• Short-term Investment Decision
- Corporations sometimes have a substantial
amount of excess cash available for a short time
period.
• Long-term Financing Decision
- Corporations that issue bonds to secure long-
term funds may prefer that the currency
borrowed, depreciate over time against the
currency they are receiving from sales.
 Forecasting Determination
1. Technical Forecasting ---- Statistical analysis and
Time series models
2. Fundamental Forecasting ---- Based on
fundamental relationship between economic
variables and exchange rates.
3. Market Based Forecasting ---- Developing from
market indicators (Spot rate & Forward rate)
 Abhay Kumar Gupta [Subject: Management/Commerce] International Vol. 4, Issue: 5, July: 2016
Journal of Research in Humanities & Soc. Sciences [I.F. = 0.564] ISSN:(P) 2347-5404 ISSN:(O)2320 771X

Hedging Tools and Techniques for Foreign

Exchange Exposure in India
ABHAY KUMAR GUPTA
Assistant professor,
Sri Aurobindo College
Delhi (India)

Abstract:
In recent years, there has been spontaneous and unpredictable fluctuation in the value of Indian
rupee. The paper looks at the necessity of managing foreign exchange rate exposure, and ways by
which it can be accomplished. This paper discusses exchange rate exposure in terms of transaction
risk (sensitivity of firm's future cash flows from contracts denominated in foreign currency to changes
in exchange rate), translation risk (sensitivity of firm's foreign denominated financial statements to
changes in exchange rate) and economic risk (sensitivity of firm's competitive position in the market
to changes in exchange rate). It identifies various steps involved in foreign exchange risk
management process. This paper seeks to analysis the various options available to the Indian
corporates for hedging exchange rate exposure.

Keywords: Derivatives, Exposure, Hedging, Risk management

1. Introduction
With the fall of fixed exchange regime in 1973, exchange rates between currencies were determined
by market forces of demand and supply leading to the advent of fluctuating exchange rate regime.
This brought with it randomness and unpredictability in exchange rates. Exchange rates have become
more volatile than they were expected. This random fluctuation in exchange rate has made cash flows
and asset value of companies dealing in different currencies unpredictable, that is to say, cash flows
and asset value of MNCs in their respective domestic currency are at stake of exchange rate between
its domestic currency and foreign currency. Thus, Foreign Exchange Exposure is risk associated with
unanticipated changes in exchange rate.

With globalization and liberalization of Indian economy in nineties, scope of business for Indian
companies with the rest of world has broadened and foreign corporations too have become much
interested in India. In India, exchange rates were deregulated and were allowed to be determined by
markets in 1993. This volatility in exchange rates can have detrimental effect on the firm’s financial
position and negative effect on its competitive position in the market and value of firm, if ignored it
can paralyze the company.

2. Significance of Study
In 1992-93 Budget provided for partial convertibility of Indian Rupee in current accounts and, in
March 1993, the Rupee was made fully convertible in current Account. Since then, there has been
continuous increase in foreign investment in India. Multi-national corporations are entering the Indian
market with their products and services either through subsidiaries or joint venture. Indian corporate
houses are also involved in cross border transactions with different countries and in different
products. Indian firms have also started raising funds from international financial sources. Rupee
depreciated against dollar by about 24% between March 2008 and March 2009 from Rs. 39.80 to Rs.
52.20. And it depreciated against dollar by about 6.23% between June 2014 and June 2014. This
48 Online & Print International, Refereed, Impact factor & Indexed Monthly Journal www.raijmr.com
RET Academy for International Journals of Multidisciplinary Research (RAIJMR)
 Abhay Kumar Gupta [Subject: Management/Commerce] International Vol. 4, Issue: 5, July: 2016
Journal of Research in Humanities & Soc. Sciences [I.F. = 0.564] ISSN:(P) 2347-5404 ISSN:(O)2320 771X
impulsive and volatile change in exchange rate makes the environment unpredictable making the
business decisions complicated and this volatility can negatively affect the firm's cash flows and
value. The paper looks at the necessity of managing foreign exchange rate exposure, and discusses the
measures that can be taken to mitigate foreign exchange risk. It identifies various steps involved in
foreign exchange risk management process. This paper attempts to evaluate the various alternatives
available to the Indian corporates and foreign business houses operating in India for hedging
exchange rate exposure. The financial stability report published by RBI in Dec 2012 mentions
“excessive volatility in exchange rate makes it difficult for economic agents to make optimal
intertemporal decisions. The economic agents, therefore, need to properly understand and measure the
nature of currency risk embedded in their business and use appropriate derivative instruments to
hedge their currency risk..."

3. Objectives of Study
This paper identifies various types of foreign exchange exposures in MNCs operating in India. The
focal point of this paper is identification of various tools and techniques to mitigate foreign exchange
exposure of companies operating in India. Objectives of the study have been to discuss foreign
exchange risk management process and the steps involved in it and to examine the facilities available
for managing foreign exchange exposure in India.

4. Literature Review
Bradford Cornell and Alan C. Shapiro (1983) described how foreign exchange risk can be managed.
Ian H. Giddy and Gunter Dufey, in their article “The Management of Foreign Exchange risk”,
identified that in many realistic situations, the economic effects of randomness of exchange rate are
different from those predicted by the various measures of translation exposure. It emphasizes the
distinctions between the currency of location, the currency of denomination and the currency of
determination of a business. They argued that a market based approach be followed in international
financial planning.

Fok et al. (1997) have found that hedging not only reduces variability in earnings but it also increases
firm value. They found that hedging not only decreases the chances of financial distress but also the
agency costs of debt and the costs of equity.

Chowdhry and Howe (1999) argue that firms use financial instruments to hedge short term exposure
and for managing long-run operating exposure, they use long-term strategy adjustments (i.e.,
operational hedges).

Niclas hagelin and bengt pramborg (2002) investigated the effectiveness of currency derivatives and
foreign denominated debt in reducing foreign exchange exposure. The results were positive.

Sathya Swaroop Debasish (2008) studied the foreign exchange risk management practices of 501 non-
banking Indian firms to identify the techniques which they use to hedge their foreign exchange risk. It
was revealed that volatility and reduction in cash flows was the rationale behind hedging. The
techniques used by Indian firms are forward contracts, swaps and cross-currency options. Confused
perception about derivative use, technical and administrative constraints and fear of high cost were
found to the main reasons of not pursuing any foreign exchange risk management technique. The
paper discusses the various foreign exchange risk management techniques.

Jain, Yadav, and Rastogi (2009) discusses and compares the foreign exchange risk management
strategies and interest rate risk management strategies followed by public companies, private business
houses and foreign companies operating in India. All the risks are not managed. Management of these
companies operating in India are of opinion that amount of exposer accruing to these do not require to
be specially managed.
49 Online & Print International, Refereed, Impact factor & Indexed Monthly Journal www.raijmr.com
RET Academy for International Journals of Multidisciplinary Research (RAIJMR)
 Abhay Kumar Gupta [Subject: Management/Commerce] International Vol. 4, Issue: 5, July: 2016
Journal of Research in Humanities & Soc. Sciences [I.F. = 0.564] ISSN:(P) 2347-5404 ISSN:(O)2320 771X
Peter mbabazi mbabazize, twesige daniel and issac emukule ekise(2014) found that exporting firms in
Uganda had a significant relationship between currency risk transfer strategies and gross profit
margin, net profit margin and sales growth.

5. Research Methodology
Extensive literature review of books, journals, articles and other published data related to the focus of
the study, and also concerned websites, was done to gather background information about the general
nature of the research problem.

6. Types of Foreign Exchange Exposure

1. Translation exposure
It is the sensitivity of firm's foreign currency denominated financial statements to changes in
exchange rate. Financial statements of foreign subsidiary are to be translated in home country
currency for finalizing the accounts for any given period and holding companies has to prepare
consolidated financial statements. Fluctuation in exchange rates will make the value of assets and
profit amount different depending on different exchange rate applied. So value of same assets and
profit would be different for different period. Thus, Translation exposure arises on the consolidation
of assets, liabilities and profits denominated in foreign currency in the process of preparing
consolidated accounts. It can be measured as Translation exposure = (exposed assets - exposed
liabilities) (change in exchange rate)
2. Transaction Exposure
It is the sensitivity of firm's future cash flows from contracts denominated in foreign currency to
changes in exchange rate. It is a measure of change in the value of outstanding financial obligations
which are denominated in foreign currency. In other words, Transaction risk refers to the impact of
exchange rate changes on the value of committed cash flows i.e. future cash flows for which nominal
value is known. Marshall (2000) found that US, UK and Asian Companies focuses on management of
transaction risk only.
3. Economic Exposure
It is the sensitivity of firm's competitive position in the market to changes in exchange rate. It refers to
the possibility of the change in the present value of the firm's expected future cash flows due to
unexpected change in exchange rates. It is also called operating exposure. It measures the change in
the present value of the firm, which results from any change in future operating cash flows caused by
unexpected exchange rates fluctuation. Pantzalis et al (2001) defines Operating exposure as the effect
of unexpected changes in the exchange rate on cash flows associated with a firm's real assets and
liabilities. It affects the profitability of the firm over a longer period than transaction and translation
exposure.

7. Foreign Exchange Risk Management

1. Identification and quantification of exposure
Business cycle of the company is analyzed to identify where foreign exchange risk exists. Future cash
flow which are confirm to arise out of contracts already entered and future foreign currency cash
flows which are not confirm over the time period are forecasted and measured to get the foreign
exchange exposure. After measuring the level of exposure of the company, decision is to be made
regarding what magnitude of risk is to be hedged and how much risk is to be covered.
2. Policy formulation
Effective FERM requires well-framed policies, clear objectives and parameters within which the
strategy is to be controlled. These policies should clearly mention the principles which is to be
followed and extent of hedging (risk coverage) which are needed. Objectives should set standard for
bank’s exposure to foreign exchange risk; and personnel are appointed who have the authority to trade
in foreign exchange on behalf of company; and should mention the different currencies, which have
been approved for transaction within the company. There should be some stop loss arrangements to
prevent the firm from abnormal losses if the forecasts turn out wrong. There should be monitoring
50 Online & Print International, Refereed, Impact factor & Indexed Monthly Journal www.raijmr.com
RET Academy for International Journals of Multidisciplinary Research (RAIJMR)
 Abhay Kumar Gupta [Subject: Management/Commerce] International Vol. 4, Issue: 5, July: 2016
Journal of Research in Humanities & Soc. Sciences [I.F. = 0.564] ISSN:(P) 2347-5404 ISSN:(O)2320 771X
systems to detect critical levels in the foreign exchange rates where appropriate measure is required.
3. Hedging
After formulating policies, the firms then decides about an appropriate hedging strategies keeping in
mind the principles and objectives and extent of exposure coverage. There are various financial
instruments available for the firm to mitigate its risk- futures, forwards, options and swaps and issue
of foreign debt. Hedging strategies and instruments are explained later.
4. Reporting and Review
Risk management policies are periodically reviewed based on periodic reports prepared. These
periodic reports measure the effectiveness of hedging strategy adopted by the company to mitigate its
foreign exchange exposure. The review of risk management policies are done to judge the validity of
benchmarks set; whether they are effective in controlling the exposures; what the market trends are
and whether the overall strategy is enough or change is required in it.

8. Hedging Tools and techniques

8.1 External techniques
1. Forward Contracts
Forward contracts involve an agreement between two parties to buy/sell a specific quantity of an
underlying asset at a fixed price on a specified date in the future. In other words, Forward contracts
are those where counterparty agrees to exchange a specified quantity of an asset at a future date for a
price agreed today. These are the most commonly used foreign exchange risk management tools. The
corporations can enter into forward contracts for the foreign currencies which it need for payment or
which it will receive in future. Since the rate of exchange is already fixed for the future transaction,
there will be no variability in the cash flows. Hence, changes that take place between the contract date
and the actual transaction date does not make any impact. This will eliminate the foreign exchange
exposure. The future settlement date can be an exact date or any time between two agreed dates.
2. Currency Futures
Currency futures contract involves a standardized contract between two parties to buy/sell an amount
of currency at a fixed price on a specified date in the future and are traded on organized exchanges.
Futures contracts are more liquid than forward contracts as they are traded in an organized exchange.
A depreciation of currency can be hedged by selling futures and currency appreciations can be hedged
by buying futures. Thus, inflow and outflow of different currencies with respect to each other can be
fixed by selling and buying currency futures, eliminating the Foreign Exchange Exposure.
3. Currency Options
Currency options are contracts which provides the holder the right to buy or sell a specified amount of
currency for a specified price over a given time period. Currency options give the owner of the
agreement the right to buy or sell but not an obligation. The owner of the agreement has a choice
whether to use or not to use the option based on the exchange rates. He/she can choose to sell or buy
the currency or let the option lapse. The writer of the option gets a price for granting this option. The
price payable is known as premium. The fixed price at which the owner can sell or buy the currency is
called as strike price or the exercise price. Options giving the holder a right to buy are called call
options and Options giving the holder a right to sell is called put options. It is possible to take
advantage of the potential gains through currency options. For example, If an Indian business firm has
to purchase capital goods from the USA in US$ after three months, the company should buy a
currency call option. There are two possibilities. First, if the dollar depreciates, then the exchange
rates will be favorable as spot rate will be less than the strike price and the company can buy the US$
at the prevailing spot rate, as it will cost less. Second, if the dollar appreciates, then the exchange rates
will be unfavorable as spot rate will be more than the strike price and the company can opt to use its
right and buy the US$ at the strike price. Hence, in both the cases the company will be paying the less
to buy the dollar to pay for the goods.
4. Currency Swaps
A currency swap involves an agreement between two parties to exchange a series of cash flows in one
currency for a series of cash flows in another currency, at agreed intervals over an agreed period. This
51 Online & Print International, Refereed, Impact factor & Indexed Monthly Journal www.raijmr.com
RET Academy for International Journals of Multidisciplinary Research (RAIJMR)
 Abhay Kumar Gupta [Subject: Management/Commerce] International Vol. 4, Issue: 5, July: 2016
Journal of Research in Humanities & Soc. Sciences [I.F. = 0.564] ISSN:(P) 2347-5404 ISSN:(O)2320 771X
is done to convert a liability in one currency to some other currency. Its purpose is to raise funds
denominated in other currency. One party holding one currency swaps it for another currency held by
other party. Each party would pay the interest for the exchanged currency at regular interval of time
during the term of the loan. At maturity or at the termination of the loan period each party would re-
exchange the principal amount in two currencies.
5. Foreign Debt
Foreign debts are an effective way to hedge the foreign exchange exposure. This is supported by the
International Fischer Effect relationship. For example, a company is expected to receive a fixed
amount of Euros at a future date. There is a possibility that the company can experience loss if the
domestic currency appreciates against the Euros. To hedge this, company can take a loan in Euros for
the same time period and convert the foreign currency into domestic currency at the spot exchange
rate. And when the company receives Euros, it can pay off its loan in Euros. Hence the company can
completely eliminate its foreign exchange exposure.
6. Cross Hedging
Cross Hedging means taking opposing position in two positively correlated currencies. It can be used
when hedging of a particular foreign currency is not possible. Even though hedging is done in a
different currency, the effects would remain the same and hence cross hedging is an important
technique that can be used by companies.
7. Currency Diversification
Currency Diversification means investing in securities denominated in different currencies.
Diversification reduces the risk even if currencies are non-correlated. It will give the company global
exposure, minimize foreign exchange exposure and capitalize on exchange rate disparities.

9. Internal Techniques
A. Netting
Netting implies offsetting exposures in one currency with exposure in the same or another currency,
where exchange rates are expected to move high in such a way that losses or gains on the first
exposed position should be offset by gains or losses on the second currency exposure. It is of two
types of bilateral netting & multilateral netting. In bilateral netting, each pair of subsidiaries nets out
their own positions with each other. Flows are reduced by the lower of each company’s purchases
from or sales to its netting partner.
B. Matching
Matching refers to the process in which a company matches its currency inflows with its currency
outflows with respect to amount and timing. When a company has receipts and payments in same
foreign currency due at same time, it can simply match them against each other. Hedging is required
for unmatched portion of foreign currency cash flows. This kind of operation is referred to as natural
matching. Parallel matching is another possibility. When gains in one foreign currency are expected to
be offset by losses in another, if the movements in two currencies are parallel is called parallel
matching.
C. Leading and Lagging
These involve adjusting the timing of the payment or receivables. Leading is accelerating payment of
strengthening currencies and speeding up the receipt of weakening currencies. Lagging is delaying
payment of weakening currencies and postponing receipt of strengthening currencies. In these the
payable or receivable of the foreign currency is postponed in order to benefit from the movements in
exchange rates.
D. Pricing Policy
There can be two types of pricing tactics: price variation and currency of invoicing policy. Price
variation can be done as increasing selling prices to offset the adverse effects of exchange rate
fluctuations. However, it may affect the sales volume. So proper analysis should be done regarding
customer loyalty, market position, competitive position before increasing price. Secondly, foreign
customers can be insisted to pay in home currency and paying all imports in home currency.

52 Online & Print International, Refereed, Impact factor & Indexed Monthly Journal www.raijmr.com
RET Academy for International Journals of Multidisciplinary Research (RAIJMR)
 Abhay Kumar Gupta [Subject: Management/Commerce] International Vol. 4, Issue: 5, July: 2016
Journal of Research in Humanities & Soc. Sciences [I.F. = 0.564] ISSN:(P) 2347-5404 ISSN:(O)2320 771X
E. Government Exchange Risk Guarantee
Government agencies in many countries provide insurance against export credit risk and introduce
special export financing schemes for exporters in order to promote exports. In recent years a few of
these agencies have begun to provide exchange risk insurance to their exporters and the usual export
credit guarantees. The exporter pays a small premium on his export sales and for this premium the
government agency absorbs all exchange losses and gains beyond a certain level.

10. Conclusion
Foreign exchange exposure management is too important to be ignored by businesses across the
world, including emerging world like India. Businesses which did not give due care to it have paid the
penalty. Business firms need to be proactive in foreign exchange risk management. Firms need to
look at instituting a sound risk management system and also need to formulate their hedging strategy
that suits their specific firm characteristics and exposures. In India, regulation has been steadily eased
and turnover and liquidity in the foreign currency derivative markets have increased, although the use
is mainly in shorter maturity contracts of one year or less. Forward and option contracts are the more
popular instruments. Initially only certain banks were allowed to deal in this market however now
corporate can also write option contracts. Indian companies are actively hedging their foreign
exchanges risks with forwards and currency swaps and different types of options. Introduction of
Cross-Currency Futures and Exchange Traded Option Contracts by the RBI will further enhance the
companies’ ability to effectively manage foreign exchange exposure. A larger interactive model
capable of culminating all facets of enterprise-wide risk management needs to be developed. It is
concluded that business and industry should invariably hedge their actual risk exposures without
exception as a base case strategy as it is most conservative and prudent strategy. Government should
make appropriate policy and took measures that can accelerate the process of further development of
foreign exchange market. Companies should upgrade their foreign exchange risk management
(FERM) process and employ innovative tools to mitigate foreign exchange exposure.

References
1. Anuradha Sivakumar and Runa Sarkar, ''Corporate Hedging for Foreign Exchange Risk in India''
2. Björn Döhring, "Hedging and invoicing strategies to reduce exchange rate exposure: a euro-area
perspective"
3. Bradford Cornell and Alan C. Shapiro (1983). “Managing Foreign Exchange Risks”
4. Brown, G. (2001), "Managing foreign exchange risk with derivatives"
5. Chowdhry and Howe (1999). ''Corporate risk management for multinational corporations;
financial and operational hedging policies''
6. David A. Carter, Christos Pantzalis, and Betty J. Simkins, (2001). "Firmwide Risk Management
of Foreign Exchange Exposure by U.S. Multinational Corporations"
7. Stephen, D. Maker and Stephen P. Huffman, "Foreign currency risk management practices in
U.S. multinationals"
8. Financial Markets Regulation Department, RBI, A.P. (DIR Series) Circular No. 35 RBI/2015
9. Florentina-Olivia Bãlu and Daniel Armeanu, “Foreign Exchange Risk in International
Transactions”, Theoretical and Applied Economics, 65
10. Ian H. Giddy and Gunter Dufey, “The Management of Foreign Exchange risk”
11. Michael Papaioannou, (2006). “Exchange Rate Risk Measurement and Management: Issues and
Approaches for Firms”, IMF Working Paper, Monetary and Capital Markets, WP/06/255
12. Niclas hagelin and bengt pramborg (2002). ''hedging foreign exchange exposure: risk reduction
from transaction and translation hedging",
13. Varma, Jayanth R. "Indian Financial Sector after a Decade of Reforms"
14. Sagi rajkumar varma, "Foreign exchange risk management in India: issues and challenges"
15. Sathya Swaroop Debasish (2008). “Foreign Exchange Risk Management Practices – A Study in
Indian Scenario”
16. Sharma, V.K." The Risk management imperative"
53 Online & Print International, Refereed, Impact factor & Indexed Monthly Journal www.raijmr.com
RET Academy for International Journals of Multidisciplinary Research (RAIJMR)
IEOR E4706: Foundations of Financial Engineering
c 2016 by Martin Haugh

Forwards, Swaps, Futures and Options

These notes1 introduce forwards, swaps, futures and options as well as the basic mechanics of their associated
markets. We will also see how to price forwards and swaps, but we will defer the pricing of futures contracts
until after we have studied martingale pricing. We will see how to price options within the binomial model
framework.
With the exception of the binomial model in Section 4, the underlying probability structure of the financial
market plays only a small role in these notes. Nonetheless, you should not be under the impression that the
results we derive only hold for deterministic models and are therefore limited in scope. On the contrary, many of
the results we derive are very general and hold irrespective of the underlying probability structure that we might
find ourselves working with.
Finally, we mention that it is easy to compute the value of a deterministic cash flow given the current
term-structure of interest rates and we will often make use of this observation when pricing forwards and swaps.
Pricing securities with stochastic cash-flows is more complicated and requires more sophisticated no-arbitrage or
equilibrium methods. The binomial model of Section 4, however, provides a simple yet important model for
introducing some of these methods. We will study them in more generality and much greater detail when we
study martingale pricing later in the course.

1 Forwards
Definition 1 A forward contract on a security (or commodity) is a contract agreed upon at date t = 0 to
purchase or sell the security at date T for a price, F , that is specified at t = 0.

When the forward contract is established at date t = 0, the forward price, F , is set in such a way that the initial
value of the forward contract, f0 , satisfies f0 = 0. At the maturity date, T , the value of the contract is given2
by fT = ±(ST − F ) where ST is the time T value of the underlying security (or commodity). It is very
important to realize that there are two “prices” or “values” associated with a forward contract at time t: ft
and F . When we use the term “contract value” or “forward value” we will always be referring to ft , whereas
when we use the term “contract price” or “forward price” we will always be referring to F . That said, there
should never be any ambiguity since ft is fixed (equal to zero) at t = 0, and F is fixed for all t > 0 so the
particular quantity in question should be clear from the context. Note that ft need not be (and generally is not)
equal to zero for t > 0.
Examples of forward contracts include:
• A forward contract for delivery (i.e. purchase) of a non-dividend paying stock with maturity 6 months.
• A forward contract for delivery of a 9-month T-Bill with maturity 3 months. (This means that upon
delivery, the T-Bill has 9 months to maturity.)

• A forward contract for the sale of gold with maturity 1 year.

• A forward contract for delivery of 10m Euro (in exchange for dollars) with maturity 6 months.
1 Thenotes draw heavily from David Luenberger’s Investment Science (Oxford University Press, 1997).
2 If
the contact specifies a purchase of the security then the date T payoff is ST − F whereas if the contact specifies a sale of
the security then the payoff is F − ST .
Forwards, Swaps, Futures and Options 2

1.1 Computing Forward Prices

We first consider forward contracts on securities that can be stored at zero cost. The origin of the term “stored”
is that of forward contracts on commodities such as gold or oil which typically are costly to store. However, we
will also use the term when referring to financial securities. For example, while non-dividend paying stocks and
zero-coupon bonds may be stored at zero cost, it is also the case that dividend paying stocks and coupon paying
bonds can be stored at a negative cost.

Forward Contracts on Securities with Zero Storage Costs

Suppose a security can be stored at zero cost and that short3 selling is allowed. Then the forward price, F , at
t = 0 for delivery of that security at date T is given by

F = S/d(0, T ) (1)

where S is the current spot price of the security and d(0, T ) is the discount factor applying to the interval [0, T ].
Proof: The proof works by constructing an arbitrage portfolio if F 6= S/d(0, T ).
Case (i): F < S/d(0, T ): Consider the portfolio that at date t = 0 is short one unit of the security, lends S
until date T , and is long one forward contract. The initial cost of this portfolio is 0 and it has a positive payoff,
S/d(0, T ) − F , at date T . Hence it is an arbitrage.
Case (ii): F > S/d(0, T ): In this case, construct the reverse portfolio and again obtain an arbitrage
opportunity.

Example 1 (A Forward on a Non-Dividend Paying Stock)

Consider a forward contract on a non-dividend paying stock that matures in 6 months. The current stock price
is $50 and the 6-month interest rate is 4% per annum. Compute the forward price, F .
Solution: Assuming semi-annual compounding, the discount factor is given by d(0, .5) = 1/1.02 = 0.9804.
Equation (1) then implies that F = 50/0.9804 = 51.0.

Forward Contracts on Securities with Non-Zero Storage Costs

Suppose now that we wish to compute the forward price of a security that has non-zero storage costs. We will
assume that we are working in a multi-period setting and that the security has a deterministic holding cost of
c(j) in period j, payable at the beginning of the period. Note that for a commodity, c(j) will generally represent
a true holding cost, whereas for a stock or bond, c(j) will be a negative cost and represent a dividend or coupon
payment.

Forward Price for a Security with Non-Zero Storage Costs: Suppose a security can be stored for
period j at a cost of c(j), payable at the beginning of the period. Assuming that the security may also be sold
short, then the forward price, F , for delivery of that security at date T (assumed to be M periods away) is given
by
M −1
S X c(j)
F = + (2)
d(0, M ) j=0
d(j, M)

where S is the current spot price of the security and d(j, M ) is the discount factor between dates j and M .
Proof: As before, we could prove (2) using an arbitrage argument. An alternative proof is to consider the
strategy of buying one unit of the security on the spot market at t = 0, and simultaneously entering a forward
contract to deliver it at time T . The cash-flow associated with this strategy is

(−S − c(0), −c(1), . . . , −c(j), . . . , −c(M − 1), F )

3 The act of short-selling a security is achieved by first borrowing the security from somebody and then selling it in the

market. Eventually the security is repurchased and returned to the original lender. Note that a profit (loss) is made if the
security price fell (rose) in value between the times it was sold and purchased in the market.
Forwards, Swaps, Futures and Options 3

and its present value must (why?) be equal to zero. Since the cash-flow is deterministic we know how to
compute its present value and we easily obtain (2).

Example 2 (A Bond Forward)

Consider a forward contract on a 4-year bond with maturity 1 year. The current value of the bond is $1018.86,
it has a face value of $1000 and a coupon rate of 10% per annum. A coupon has just been paid on the bond
and further coupons will be paid after 6 months and after 1 year, just prior to delivery. Interest rates for 1 year
out are flat at 8%. Compute the forward price of the bond.
Solution: Note that in this problem, the ‘storage costs’ (i.e. the coupon payments) are paid at the end of the
period, which in this example is of length 6 months. As a result, we need to adjust (2) slightly to obtain
M −1
S X c(j)
F = + .
d(0, M ) j=0
d(j + 1, M )

In particular, we now obtain

1018.86 50
F = − − 50
d(0, 2) d(1, 2)
where d(0, 2) = 1.04−2 and d(1, 2) = d(0, 2)/d(0, 1) = 1.04−1 .

1.2 Computing the Value of a Forward Contract when t > 0

So far we have discussed how to compute F = F0 , the forward price at date 0 for delivery of a security at date
T . We now concentrate on computing the forward value, ft , for t > 0. (Recall that by construction, f0 = 0.)
Let Ft be the current forward price at date t for delivery of the same security at the same maturity date, T .
Then we have
ft = (Ft − F0 ) d(t, T ). (3)
Proof: Consider a portfolio that at date t goes long one unit of a forward contract with price Ft and maturity
T , and short one unit of a forward contract with price F0 and maturity T . This portfolio has a deterministic
cash-flow of F0 − Ft at date T and a deterministic cash-flow of ft at date t. The present value at date t of this
cash-flow stream, (ft , F0 − Ft ) must be zero (why?) and hence we obtain (3).

1.3 Tight Markets

Examination of equation (2) implies that the forward price for a commodity with positive storage costs should
be increasing in M . Frequently, however, this is not the case and yet it turns out that arbitrage opportunities do
not exist. This apparent contradiction can be explained by the fact that it is not always possible to short
commodities, either because they are in scarce supply, or because holders of the commodity are not willing to
lend them to would-be short sellers. The latter situation might occur, for example, if the commodity has a
utility value over and beyond its spot market value.
If short selling is not allowed, then the arbitrage argument used to derive (2) is no longer valid. In particular, we
can only conclude that
M −1
S X c(j)
F ≤ + . (4)
d(0, M ) j=0
d(j, M )

Exercise 1 Convince4 yourself that we can indeed only conclude that (4) is true if short-selling is not
permitted.
4 See Luenberger, Chapter 10, for a discussion of tight markets.
Forwards, Swaps, Futures and Options 4

In such circumstances, we say that the market is tight. An artifice that is often used to restore equality in (4) is
that of the convenience yield. The convenience yield, y, is defined in such a way that the following equation is
satisfied.
M −1
S X c(j) − y
F = + . (5)
d(0, M ) j=0
d(j, M )

The convenience yield may be thought of as a negative holding cost that measures the convenience per period
of having the commodity on hand.

2 Swaps
Another important class of derivative security are swaps, perhaps the most common of which are interest rate
swaps and currency swaps. Other types of swaps include equity and commodity swaps. A plain vanilla swap
usually involves one party swapping a series of fixed level payments for a series of variable payments.
Swaps were introduced primarily for their use in risk-management. For example, it is often the case that a party
faces a stream of obligations that are floating or stochastic, but that it will have to meet these obligations with
a stream of fixed payments. Because of this mismatch between floating and fixed, there is no guarantee that the
party will be able to meet its obligations. However, if the present value of the fixed stream is greater than or
equal to the present value of the floating stream, then it could purchase an appropriate swap and thereby ensure
than it can meet its obligations.

2.1 Plain Vanilla Interest Rate Swaps

In a plain vanilla interest rate swap, there is a maturity date, T , a notional principal, P , and a fixed5 number of
periods, M . There are two parties, A and B say, to the swap. Every period party A makes a payment to party
B corresponding to a fixed rate of interest on P . Similarly, in every period party B makes a payment to party A
that corresponds to a floating rate of interest on the same notional principal, P .
It is important to note that the principal itself, P , is never exchanged. Moreover, it is also important to specify
whether the payments occur at the end or the beginning of each period.
For example, assuming cash payments are made at the end of periods, i.e. in arrears, the total aggregate cash
cash flow from party A’s perspective is given by

C = P × (0, r0 − rf , ... , rM −1 − rf )
| {z } | {z }
st th
At end of 1 period At end of M period

where rf is the constant fixed rate and ri is the floating rate that prevailed at the beginning of period i. In
general, ri will be stochastic and so the swap’s cash-flow, C, will also be stochastic. As is the case with forward
contracts, the value X (equivalently rf ) is usually chosen in such a way that the initial value of the swap is zero.
Even though the initial value of the swap is zero, we say that party A is “long” the swap and party B is “short”
the swap.

Exercise 2 Make sure you understand how to use the terms “long” and “short” when referring to a swap.

2.2 Currency Swaps

A simple type of currency swap would be an agreement between two parties to exchange fixed rate interest
payments and the principal on a loan in one currency for fixed rate interest payments and the principal on a loan
in another currency. Note that for such a swap, the uncertainty in the cash flow is due to uncertainty in the
currency exchange rate. In a Dollar/Euro swap, for example, a US company may receive the Euro payments of
5 It is assumed that the date of the terminal payment coincides with the maturity date, T .
Forwards, Swaps, Futures and Options 5

the swap while a German company might receive the dollar payments. Note that the value of the swap to each
party will vary as the USD/Euro exchange rate varies. As a result, the companies are exposed to foreign
exchange risk but if necessary this risk can be hedged by trading in the forward foreign exchange market.
Why might the US and German companies enter such a transaction? A possible explanation might be that the
US company wishes to invest in the Eurozone while the German country wishes to invest in the U.S. Each
company therefore needs foreign currency. However, they may have a comparative advantage borrowing in their
domestic currency at home as opposed to borrowing in a foreign currency abroad. If this is the case, it makes
sense to borrow domestic currency at home and use a swap to convert it into the foreign currency.

2.3 Pricing Swaps

Pricing swaps is quite straightforward. For example, in the currency swap described above, it is easily seen that
the swap cash-flow is equivalent to being long a bond in one currency and short the bond in another currency.
Therefore, all that is needed to price6 the swap is the term structure of interest rates in each currency (to price
the bonds) and the spot currency exchange rate.
More generally, we will see that the cash-flow stream of a swap can often be considered as a stream of forward
contracts. Since we can price forward contracts, we will be able to price7 swaps. We will see how to do this by
way of the first example below where we price a commodity swap.

Example 3 (Pricing a Commodity Swap)

Let Si be the spot price of a commodity at the beginning of period i. Party A receives the spot price for N
units of the commodity and pays a fixed amount, X, per period. We will assume that payments take place at
the beginning of the period and there will be a total of M payments, beginning one period from now. The
cash-flow as seen by the party that is long the swap is

C = N × (0, S1 − X, S2 − X, . . . , SM − X) .

Note that this cash-flow is stochastic and so we cannot compute its present value directly by discounting.
However, we can decompose C into a stream of fixed payments (of −N X) that we can easily price, and a
stochastic stream, N (0, S1 , S2 , . . . , SM ). The stochastic stream is easily seen to be equivalent to a stream
of forward contacts on N units of the commodity. We then see that receiving N Si at period i has the same
value of receiving N Fi at period i where Fi is the date 0 forward price for delivery of one unit of the commodity
at date i. As the forward prices, Fi , are deterministic and known at date 0, we can see that the value of the
commodity swap is given by
XM
V = N d(0, i)(Fi − X).
i=1

X is usually chosen so that the initial value of V is zero.

Example 4 (Pricing an Interest Rate Swap)

Party A agrees to make payments of a fixed rate of interest, rf , on a notional principal, P , while receiving
floating rate payments on P for M periods. We assume that the payments are made at the end of each period
and that the floating rate payment will be based on the short rate that prevailed at the beginning of the period.
The cash-flow corresponding to the long side of the swap is then given by

C = P (0, r0 − rf , r1 − rf , . . . , rM −1 − rf ).

where ri is the short rate for the period beginning at date i. Again this cash flow can be decomposed into a
series of fixed payments that can be easily priced, and a stochastic stream, P (0, r0 , r1 , . . . , rM −1 ). We can
6 As mentioned above, the fixed payment stream of a swap is usually chosen so that the initial swap value is zero. However,

once the swap is established its value will then vary stochastically and will not in general be zero.
7 Later in the course we will develop the theory of martingale pricing. Then we will be able to price swaps directly, without

needing to decompose it into a series of of forward contracts.

Forwards, Swaps, Futures and Options 6

value the stochastic stream either using an arbitrage argument or by recalling that the price of a floating rate
bond is always par at any reset point. Note that the stochastic stream is exactly the stream of coupon payments
corresponding to a floating rate bond with face value P . Hence the value of the stochastic stream must be
(why?) P (1 − d(0, M )) and so the value of the swap is given by
" M
#
X
V = P 1 − d(0, M ) − rf d(0, i) . (6)
i=1

As before, rf is usually chosen so that the initial value of the swap is zero.

3 Futures
While forwards markets have proved very useful for both hedging and investment purposes, they have a number
of weaknesses. First, forward markets are not organized through an exchange. This means that in order to take
a position in a forward contract, you must first find someone willing to take the opposite position. This is the
double-coincidence-of-wants problem. Second, because forward contracts are not exchange-traded, there can
sometimes be problems with price transparency and liquidity. Finally, in addition to the financial risk of a
forward contract, there is also counter-party risk. This is the risk that one party to the forward contract will
default on it’s obligations. These problems have been eliminated to a large extent through the introduction of
futures markets. That is not to say that forward markets are now redundant; they are not, and they are used, for
example, in the many circumstances when suitable futures markets are not available.
Perhaps the best way to understand the mechanics of a futures market is by example.

Example 5 (Cricket Futures)

We consider an example of a futures market where the futures contracts are not written on an underlying
financial asset or commodity. Instead, they are written on the total number of runs that are scored in a cricket
test match. The market opens before the cricket match takes place and expires at the conclusion of the match.
Similar futures markets do exist in practice and this example simply demonstrates that in principle, futures
markets can be created where just about any underlying variable can serve as the underlying asset.
The particular details of the cricket futures market are as follows:
• The futures market opens on June 3rd and the test match itself begins on June 15th. The market closes
when the match is completed on June 19th.
• The closing price on the first day of the market was 720. This can be interpreted as the market forecast
for the total number of runs that will be scored by both teams in the test match. This value varies
through time as new events occur and new information becomes available. Examples of such events
include information regarding player selection and fitness, current form of players, weather forecast
updates, umpire selection, condition of the field etc.
• The contract size is $1. This means if you go long one contract and the price increases by one, then you
will have $1 added to your cash balance. On the other hand, if the price had decreased by 8, say, and you
were short 5 contracts then your balance would decrease by $40. This process of marking-to-market is
usually done on a daily basis. Moreover, the value of your futures position immediately after
marking-to-market is identically zero, as any accrued profits or losses have already been added to or
subtracted from your cash balance.
In the table below we present one possible evolution of the futures market between June 3 and June 19. The
initial position is 100 contracts and it is assumed that this position is held until the test match ends on June 19.
An initial balance of $10, 000 is assumed and this balance earns interest at a rate of .005% per day. It is also
important to note that when the futures position is initially adopted the cost is zero, i.e. initially there is no
exchange of cash.
Forwards, Swaps, Futures and Options 7

Remark 1 You should make sure that you fully understand the mechanics of this futures market as these are
the same mechanics used by other futures markets.

CRICKET FUTURES CONTRACTS

Date Price Position Profit Interest Balance

June 3 720.00 100 0 0 10,000

June 4 721.84 100 184 1 10,184
June 5 721.52 100 -31 1 10,153
June 6 711.88 100 -964 1 9,190
June 7 716.67 100 479 0 9,669
June 8 720.04 100 337 0 10,006
June 9 672.45 100 -4,759 1 5,248 Any explanation?
June 10 673.25 100 80 0 5,328
June 11 687.04 100 1,379 0 6,708
June 12 670.56 100 -1,648 0 5,060
June 13 656.25 100 -1,431 0 3,630
June 14 647.14 100 -912 0 2,718
June 15 665.57 100 1,843 0 4,561 Test Match Begins
June 16 673.48 100 791 0 5,353
June 17 672.88 100 -60 0 5,293
June 18 646.63 100 -2,625 0 2,669
June 19 659.58 100 1,294 0 3,963 Test Match Ends

Total -6,042 3,963

In Example 5 we did not discuss the details of margin requirements which are intended to protect against the
risk of default. A typical margin requirement would be that the futures trader maintain a minimum balance in
her trading account. This minimum balance will often be a function of the contract value (perhaps 5% to 10%)
multiplied by the position, i.e., the number of contracts that the trader is long or short. When the balance drops
below this minimum level a margin call is made after which the trader must deposit enough funds so as to meet
the balance requirement. Failure to satisfy this margin call will result in the futures position being closed out.

3.1 Strengths and Weaknesses of Futures Markets

Futures markets are useful for a number of reasons:

• It is easy to take a position using futures markets without having to purchase the underlying asset. Indeed,
it is not even possible to buy the underlying asset in some cases, e.g., interest rates, cricket matches and
presidential elections.
• Futures markets allow you to leverage your position. That is, you can dramatically increase your exposure
to the underlying security by using the futures market instead of the spot market.
• They are well organized and designed to eliminate counter-party risk as well as the
“double-coincidence-of-wants” problem.
• The mechanics of a futures market are generally independent of the underlying ‘security’ so they are easy
to “operate” and easily understood by investors.
Forwards, Swaps, Futures and Options 8

Futures markets also have some weaknesses:

• The fact that they are so useful for leveraging a position also makes them dangerous for unsophisticated
and/or rogue investors.
• Futures prices are (more or less) linear in the price of the underlying security. This limits the types of risks
that can be perfectly hedged using futures markets. Nonetheless, non-linear risks can still be partially
hedged using futures. See, for instance, Example 7 below.

3.2 Relationship of Futures Prices to Forward and Spot Prices

While forwards and futures prices are clearly closely related, they are not equal in general. One important case
where they do coincide is when interest rates are deterministic and a proof of this may be found in Section 10.7
of Luenberger. However, we will see a more general proof of this and related results after we have studied
martingale pricing.
When interest rates are stochastic, as they are in the real world, forwards and futures prices will generally not
coincide. In particular, when movements in interest rates are positively correlated with price movements in the
asset underlying the futures contract, futures prices will tend to be higher than the corresponding forward price.
Similarly, when the correlation is negative, the futures price will tend to be lower than the forward price. We will
see an explanation for this after we have studied martingale pricing.
Another interesting question that arises is the relationship between F and E[ST ], where ST is the price of the
underlying asset at the expiration date, T . In particular, we would like to know whether F < E[ST ], F = E[ST ]
or F > E[ST ]. We can already guess at the answer to this question. Using the language of the CAPM, for
example, we would expect (why?) F < E[ST ] if the underlying security has positive systematic risk, i.e., a
positive beta.

3.3 Hedging with Futures: the Perfect and Minimum-Variance Hedges

Futures markets are of great importance for hedging against risk. They are particularly suited to hedging risk
that is linear in the underlying asset. This is because the final payoff at time T from holding a futures contract
is linear8 in the terminal price of the underlying security, ST . In this case we can achieve a perfect hedge by
taking an equal and opposite position in the futures contract.

Example 6 (Perfect Hedge)

Suppose a wheat producer knows that he will have 100, 000 bushels of wheat available to sell in three months
time. He is concerned that the spot price of wheat will move against him (i.e. fall) in the intervening three
months and so he decides to lock in the sale price now by hedging in the futures markets. Since each wheat
futures contract is for 5, 000 bushels, he therefore decides to sell 20 three-month futures contracts. Note that as
a result, the wheat producer has a perfectly hedged position.

In general, perfect hedges are not available for a number of reasons:

1. None of the expiration dates of available futures contracts may exactly match the expiration date of the
payoff, PT , that we want to hedge.
2. PT may not correspond exactly to an integer number of futures contracts.
3. The security underlying the futures contract may be different to the security underlying PT .
4. PT may be a non-linear function of the security price underlying the futures contract.
5. Combinations of all the above are also possible.
8 The final payoff is ±x(F − F ) = ±x(S − F ) depending on whether or not we are long or short x futures contracts and
T 0 T 0
this position is held for the entire period, [0, T ]. This assumes that we are ignoring the costs and interest payments associated
with the margin account. As they are of of secondary importance, we usually do this when determining what hedging positions
to take.
Forwards, Swaps, Futures and Options 9

When perfect hedges are not available, we often use the minimum-variance hedge to identify a good hedging
position in the futures markets. To derive the minimum-variance hedge, we let ZT be the cash flow that occurs
at date T that we wish to hedge, and we let Ft be the time t price of the futures contract. At date t = 0 we
adopt a position9 of h in the futures contract and hold this position until time T . Since the initial cost of a
futures position is zero, we can (if we ignore issues related to interest on the margin account) write the terminal
cash-flow, YT , as
YT = ZT + h(FT − F0 ).
Our objective then is to minimize
Var(YT ) = Var(ZT ) + h2 Var(FT ) + 2hCov(ZT , FT )
and we find that the minimizing h and minimum variance are given by
Cov(ZT , FT )
h∗ = −
Var(FT )
Cov(ZT , FT )2
Var(YT∗ ) = Var(ZT ) − .
Var(FT )
Such static hedging strategies are often used in practice, even when dynamic hedging strategies are capable of
achieving a smaller variance. Note also, that unless E[FT ] = F0 , it will not be the case that E[ZT ] = E[YT∗ ]. It
is also worth noting that the mean-variance hedge is not in general the same as the equal-and-opposite hedge.

Example 7 (Luenberger Exercise 10.14)

Assume that the cash flow is given by y = ST W + (FT − F0 )h. Let σS2 = Var(ST ), σF2 = Var(FT ) and
σST = Cov(ST , FT ). In an equal and opposite hedge, h is taken to be an opposite equivalent dollar value of the
hedging instrument. Therefore h = −kW , where k is the price ratio between the asset and the hedging
instrument. Express the standard deviation of y with the equal and opposite hedge in the form
σy = W σS × B.
That is, find B.
Solution: We have y = ST W − (FT − F0 )W k where k = S0 /F0 . Note that h is determined at date 0 and is
therefore a function of date 0 information only. It is easy to obtain
W 2 S02 2 W 2 S0
σy2 = W 2 σS2 + σ F − 2 σS,F
F02 F0
s  2
S0 σF S0 σS,F
⇒ σy = W σS 1 + − 2
F0 σ S F0 σS2
which implicitly defines B.
As a check, suppose that ST and FT are perfectly correlated. We then obtain (check) that
 
S0 σF
σy = W σS 1 −
F0 σS
which is not in general equal to 0! However, if Ft and St are scaled appropriately (alternatively we could scale
h), then we can obtain a perfect hedge.

9 A positive value of h implies that we are long the futures contract while a negative value implies that we are short. More

generally, we could allow h to vary stochastically as a function of time. We might want to do this, for example, if ZT is path
dependent or if it is a non-linear function of the security price underlying the futures contract. When we allow h to vary
stochastically, we say that we are using a dynamic hedging strategy. Such strategies are often used for hedging options and
other derivative securities with non-linear payoffs.
Forwards, Swaps, Futures and Options 10

Example 8 (Hedging Operating Profits)

A firm manufactures a particular type of widget. It has orders to supply D1 and D2 of these widgets at dates t1
and t2 , respectively. The revenue, R, of the corporation may then be written as

R = D1 P1 + D2 P2

where Pi represents the price per widget at time ti . We assume that Pi is stochastic and that it will depend in
part on the general state of the economy at date ti . In particular, we assume

Pi = aSi ei + c

where a and c are constants, Si is the time ti value of the market index, and 1 and 2 are independent random
variables that are also independent of Si . Furthermore, they satisfy E[ei ] = 1 for each i. The firm wishes to
hedge the revenue, R, by taking a position h at t = 0 in a futures contract that expires at date t2 and where the
market index is the underlying security. The date t2 payoff, Y , is then given by

Y = D1 (aS1 e1 + c) + D2 (aS2 e2 + c) + h(S2 − F0 ).

If we assume that St is a geometric Brownian motion so that St = S0 exp (µ − σ 2 /2)t + σBt where Bt is a
standard Brownian motion, we can easily find the minimum variance hedge, h∗ = −Cov(R, S2 )/Var(S2 ).

Exercise 3 Compute h∗ and the variance reduction that is achieved.

Remark 2 A more sophisticated hedge would be to choose a position of size h1 at date t = 0 and then to
update this position to h2 at date t1 where h1 and h2 are constants that are chosen at date t = 0. In this case
the resulting hedging strategy is still a static hedging strategy.
Note, however, that since h2 need not be chosen until date t1 , it makes sense to allow h2 to be a function of
available information at date t1 . In particular, we could allow h2 to depend on P1 and S1 , thereby obtaining a
dynamic hedging strategy, (h1 , h2 (P1 , S1 )). Such a strategy should be able to eliminate most of the uncertainty
in R.

Exercise 4 How would you go about solving for the optimal (h∗1 , h∗2 (P1 , S1 ))? Would you need to make an
assumption regarding F1 ?

Note that the most general class of dynamic hedging strategy would allow you to adjust h stochastically at
every date in [0, t2 ) and not just at dates t0 and t1 .

3.4 Final Remarks

As stated earlier, futures markets generally work in much the same way, regardless of the underlying asset.
Popular futures markets include interest rate futures and equity index futures. Interest futures, for example, can
be used to immunize bond portfolios by matching durations and/or convexities. Index futures are used in place
of the actual index itself for hedging index options. Of course, interest rate and index futures are also used for
many other reasons.
Sometimes the expiration dates of available futures contracts are sooner than the expiration date of some
obligation or security that needs to be hedged. In such circumstances, it is often common to roll the hedge
forward. That is, a hedging position in an available futures contract is adopted until that futures contract
expires. At this point the futures position is closed out and a new position in a different (and newly available)
futures contract is adopted. This procedure continues until the expiration date of the obligation or security.

Exercise 5 What types of risk do you encounter when you roll the hedge forward?
Forwards, Swaps, Futures and Options 11

In order to answer Exercise 5, assume you will have a particular asset available to sell at time T2 . Today, at time
t = 0, you would like to hedge your time T2 cash-flow by selling a single futures contract that expires at time T2
with the given asset as the underlying security. Such a futures contract, however, is not yet available though
there is a futures contract available at t = 0 that expires at time T1 < T2 . Moreover, upon expiration of this
contract the futures contract with expiration T2 will become available. You therefore decide to adopt the
following strategy: at t = 0 you sell one unit of the futures contract that expires at time T1 . At T1 you close out
this contract and then sell one unit of the newly available futures contract that expires at time T2 . What is your
net cash-flow, i.e. after selling the asset and closing out the futures contract, at time T2 ?
Note that we have only discussed the mechanics of futures markets and how they can be used to hedge linear
and non-linear risks. We have not seen how to compute the futures price, Ft , but instead will return to this after
we have studied martingale pricing.

4 Introduction to Options and the Binomial Model

We first define the main types of options, namely European and American call and put options.
Definition 2 A European call (put) option gives the right, but not the obligation, to buy (sell) 1 unit of the
underlying security at a pre-specified price, K, at a pre-specified time, T .

Definition 3 An American call (put) option gives the right, but not the obligation, to buy (sell) 1 unit of the
underlying security at a pre-specified price, K, at any time up to an including a pre-specified time, T .

K and T are called the strike and maturity / expiration of the option, respectively. Let St denote the price of
the underlying security at time t. Then, for example, if ST < K a European call option will expire worthless and
the option will not be exercised. A European put option, however, would be exercised and the payoff would be
K − ST . More generally, the payoff at maturity of a European call option is max{ST − K, 0} and its intrinsic
value at any time t < T is given by max{St − K, 0}. The payoff of a European put option at maturity is
max{K − ST , 0} and its intrinsic value at any time t < T is given by max{K − St , 0}.

4.1 Model Free Bounds for Option Prices

Because the underlying security price process, St , is stochastic and the option payoffs are non-linear functions of
the underlying security price, we cannot price options without a model. We can, however, obtain some
model-free bounds for options prices. We let cE (t; K, T ) and pE (t; K, T ) denote the time t prices of a European
call and put, respectively, with strike K and expiration T . Similarly, we let cA (t; K, T ) and pA (t; K, T ) denote
the time t prices of an American call and put, respectively, with strike K and expiration T . It should be clear
that the price of an American option is greater than or equal to the price of the corresponding European option.

Put-Call Parity
A very important result for European options is put-call parity. Suppose the underlying security does not pay
dividends. We then have
pE (t; K, T ) + St = cE (t; K, T ) + Kd(t, T ) (7)
where d(t, T ) is the discount factor used to discount cash-flows from time T back to time t. We can prove (7)
by considering the following trading strategy:
• At time t buy one European call with strike K and expiration T
• At time t sell one European put with strike K and expiration T

• At time t sell short 1 unit of the underlying security and buy it back at time T
• At time t lend K d(t, T ) dollars up to time T
Forwards, Swaps, Futures and Options 12

Regardless of the underlying security price, it is easy to see that the cash-flow at time T corresponding to this
strategy will be zero. No-arbitrage then implies that the value of this strategy at time t must therefore also be
zero. We therefore obtain −cE (t; K, T ) + pE (t; K, T ) + St − Kd(t, T ) = 0 which is (7).
When the underlying security does pay dividends then a similar argument can be used to obtain

pE (t; K, T ) + St − D = cE (t; K, T ) + Kd(t, T ) (8)

where D is the present value of all dividends until maturity.

Suppose now the underlying security does not pay dividends and that the events {ST > K} and {ST < K}
have strictly positive probability so that (why?) cE (t; K, T ) > 0 and pE (t; K, T ) > 0. We can then use put-call
parity to obtain
cE (t; K, T ) = St + pE (t; K, T ) − Kd(t, T ) > St − Kd(t, T ). (9)
Consider now the corresponding American call option. We obtain
n o n o
cA (t, K, T ) ≥ cE (t; K, T ) > max St − Kd(t, T ), 0 ≥ max St − K, 0 .

Therefore the price of an American call on a non-dividend-paying stock is always strictly greater than the
intrinsic value of the call option when the events {ST > K} and {ST < K} have strictly positive probability.
We have thus shown that it is never optimal to early-exercise an American call on a non-dividend paying stock
and so cA (t; K, T ) = cE (t, K, T ). Unfortunately there is no such result relating American put options to
European put options. Indeed it is sometimes optimal to early exercise an American put option even when the
underlying security does not pay a dividend.

4.2 The 1-Period Binomial Model

Consider the 1-period binomial model where the under- a uS0

lying security has a value of S0 = 100 at t = 0 and p

increases by a factor of u or decreases by a factor of d 

in the following period. We also assume that borrow- S0 ahh
h 
hhh
ing or lending at a gross risk-free rate of R is possible. hhhh
ha dS0
1−p
This means that $1 in the cash account at t = 0 will be
worth $R at t = 1. We also assume that short-sales are t=0 t=1
allowed.

Suppose now that S0 = 100, R = 1.01, u = 1.07 and d = 1/u = .9346. Some interesting questions now arise:

1. How much is a call option that pays max(S1 − 107, 0) at t = 1 worth?

2. How much is a call option that pays max(S1 − 92, 0) at t = 1 worth?
Pricing these options is easy but to price options in general we need more general definitions of arbitrage.

Definition 4 A type A arbitrage is a security or portfolio that produces immediate positive reward at t = 0
and has non-negative value at t = 1. i.e. a security with initial cost, V0 < 0, and time t = 1 value V1 ≥ 0.

Definition 5 A type B arbitrage is a security or portfolio that has a non-positive initial cost, has positive
probability of yielding a positive payoff at t = 1 and zero probability of producing a negative payoff then. i.e. a
security with initial cost, V0 ≤ 0, and V1 ≥ 0 but V1 6= 0.

We now have the following result.

Theorem 1 There is no arbitrage in the 1-period binomial model if and only if d < R < u.
Forwards, Swaps, Futures and Options 13

Proof: (i) Suppose R < d < u. Then at t = 0 we should borrow S0 and purchase one unit of the stock.
(ii) Suppose d < u < R. Then short-sell one unit of the stock at t = 0 and invest the proceeds in cash-account.
In both cases we have a type B arbitrage and so the result follows.

We will soon see the other direction, i.e. if d < R < u, then there can be no-arbitrage. Let’s return to our
earlier numerical example and consider the following questions:
1. How much is a call option that pays max(S1 − 102, 0) at t = 1 worth?
2. How will the price vary as p varies?
To answer these questions, we will construct a replicating portfolio. Let us buy x shares and invest y in the cash
account at t = 0. At t = 1 this portfolio is worth:

107x + 1.01y when S = 107

93.46x + 1.01y when S = 93.46

Can we choose x and y so that portfolio equals the option payoff at t = 1? We can indeed by solving

107x + 1.01y = 5
93.46x + 1.01y = 0

and the solution is x = 0.3693 and y = −34.1708. Note that the cost of this portfolio at t = 0 is

0.3693 × 100 − 34.1708 × 1 ≈ 2.76.

This implies the fair or arbitrage-free value of the option is 2.76.

Derivative Security Pricing in the 1-Period Binomial Model

Can we use the same replicating portfolio argument to C1 (S1 )

find the price, C0 , of any derivative security with payoff a
p
 uS0 Cu
function, C1 (S1 ), at time t = 1? Yes we can by setting
up replicating portfolio as before and solving the following 

two linear equations for x and y S0 ah
h

hhhh
hhhha
1−p dS0 Cd
uS0 x + Ry = Cu (10)
dS0 x + Ry = Cd (11) t=0 t=1

The arbitrage-free time t = 0 price of the derivative must (Why?) then be C0 := xS0 + y. Solving (10) and
(11) then yields
 
1 R−d u−R
C0 = Cu + Cd
R u−d u−d
1
= [qCu + (1 − q)Cd ]
R
1 Q
= E [C1 ] (12)
R 0
where q := (R − d)/(u − d) so that 1 − q = (u − R)/(u − d). Note that if d < R < u then q > 0 and 1 − q > 0
and so by (12) there can be (why?) no-arbitrage. We refer to (12) as risk-neutral pricing and (q, 1 − q) are the
risk-neutral probabilities. So we now know how to price any derivative security in this 1-period binomial model
via a replication argument. Moreover this replication argument is equivalent to pricing using risk-neutral
probabilities.
We also note that the price of the derivative does not depend on p! This at first appears very surprising. To
understand this result further consider the following two stocks, ABC and XYZ:
Forwards, Swaps, Futures and Options 14

Stock ABC Stock XYZ

p = .99 
a 110 p = .01 
a 110
 
 
S0 = 100  S0 = 100 
ah
 hhhh ahh
h 
hhh hhhh
ha 90 hha 90
hh hh
1 − p = .01 1 − p = .99

t=0 t=1 t=0 t=1

Note that the probability of an up-move for ABC is p = .99 whereas the probability of an up-move for XYZ is
p = .01. Consider now the following two questions:
Question: What is the price of a call option on ABC with strike K = $100?
Question: What is the price of a call option on XYZ with strike K = $100?
You should be surprised by your answers. But then if you think a little more carefully you’ll realize that the
answers are actually not surprising given the premise that two stocks like ABC and XYZ actually exist
side-by-side in the market.

4.3 The Multi-Period Binomial Model

122.5


Consider the multi-period binomial model displayed to 114.49
PP
the right where as before we have assumed u = 1/d = 107
 PP 107
P
1.07. The important thing to notice is that the multi-  PP
PP 100 

period model is just a series of 1-period models spliced 100 P 
PP P
together! This implies all the results from the 1-period PP93.46  PP
PP93.46
PP 
model apply and that we just need to multiply 1-period PP 
P87.34


probabilities along branches to get probabilities in the PP
PP
multi-period model. PP81.63

t=0 t=1 t=2 t=3

Pricing a European Call Option

Q
22.5
Suppose now that we wish to price a European call option 122.50
15.48 q3
with expiration at t = 3 and strike = $100. As before we 
114.49
assume a gross risk-free rate of R = 1.01 per period. We 10.23 PPP 7
can do this by working backwards in the lattice starting 107  P
P107 3q 2 (1 − q)
6.57  P P 3.86 
at time t = 3 and using what we know about 1-period 100
 P 100 
PP 2.13 PP
PP
 0
binomial models to obtain the price at each prior node. PP93.46  93.46
3q(1 − q)2
PP
We do this repeatedly until we obtain the arbitrage-free

PP 0 
PP 87.34
price at t = 0. The price of the option at each node is PP  0
PP 81.63
displayed above the underlying stock price in the binomial P P (1 − q)3
model to the right. Note that we repeatedly used (12) t=0 t=1 t=2 t=3
to obtain these prices.
For example, the upper node at t = 1 has a value of 10.23. This is the value of the derivative security that pays
either 15.48 (after an up-move) or 3.88 (after a down-move) 1 period later. It is not hard to see that the
process of backwards evaluation that we just described is equivalent to pricing the option as
1 Q
C0 = E [max(ST − 100, 0)] (13)
R3 0
Forwards, Swaps, Futures and Options 15

and we note the risk-neutral probabilities for ST are displayed at the far right in the binomial lattice above.
Risk-neutral pricing pricing via (13) has the advantage of not needing to calculate the option price at every
intermediate node.
Question: How would you find a replicating strategy for the option?

Pricing an American Put Option

We can price American options in the same way as Euro-

0
pean options only now at each node we must also check 122.50
to see if it’s optimal to early exercise there. Recall, how- 0


ever, that it is never optimal to early exercise an American 114.49
1.26 PPP 0
call option on non-dividend paying stock. So instead will 107   PP107
3.82  2.87 P
price an American put option with expiration at t = 3 
PP
PP 100 

and strike K = $100. Once again we assume R = 1.01. 100
PP 7.13 PP
PP

6.54
The American option price at each node is displayed in PP 93.46  PP 93.46
PP 12.66 P
the lattice to the left. As before we start at expiration PP 

PP 87.34
t = 3 where we know the value of the option. We then PP 
18.37
PP
work backwards in the lattice and at each node we set PPP81.63
the value equal to the maximum of the intrinsic value and
the (risk-neutral) expected discounted value one period t=0 t=1 t=2 t=3
ahead.

For example, the value of the option at the lower node at time t = 2 is given by
 
1
12.66 = max 12.66, (q × 6.54 + (1 − q) × 18.37)
R

where 12.66 = 100 − 87.34 is the intrinsic value of the option at that node. More generally, the value, Vt (S), of
the American put option at any time t node when the underlying price is S can be computed according to
 
1
Vt (S) = max K − S, [q × Vt+1 (uS) + (1 − q) × Vt+1 (dS)]
R
 
1 Q
= max K − S, Et [Vt+1 (St+1 )] .
R

We will return to option pricing in much greater generality when we study martingale pricing.
Forwards, Swaps, Futures and Options 16

Appendix A: Calibrating the Binomial Model to Geometric Brownian Motion

In continuous-time models, it is often assumed that a security price process follows a geometric Brownian motion
(GBM) which is the continuous-time analog to the binomial model. In that case we write St ∼ GBM(µ, σ) if
2
/2)s + σ(Bt+s −Bt )
St+s = St e(µ−σ (14)
where Bt is a standard Brownian motion. Note that this model (like the binomial model) has the nice property
that the gross return, Rt,t+s , in any period, [t, t + s], is independent of returns in earlier periods. In particular, it
is independent of St . This follows by noting
St+s 2
+ σ(Bt+s −Bt )
Rt,t+s = = e(µ−σ /2)s
St
and noting the independent increments property of Brownian motion. It is appealing that Rt,t+s is independent
of St since it models real world markets where investors care only about returns and not the absolute price level
of securities. The binomial model has similar properties since the gross return in any period of the binomial
model is either u or d, and this is independent of what has happened in earlier periods.
We often wish to calibrate the binomial model so that its dynamics match that of the geometric Brownian
motion in (14). To do this we need to choose u, d and p, the real-world probability of an up-move,
appropriately. There are many possible ways of doing this, but one of the more common10 choices is to set
eµ∆t − d
p = (15)
u−d
√
u = exp(σ ∆t)
√
d = 1/u = exp(−σ ∆t)
where T is the expiration date and ∆t is the length of a period. Note then, for example, that
E[Si+1 |Si ] = puSi + (1 − p)dSi = Si exp(µ∆t), as desired. We will choose the gross risk-free rate per period,
R, so that it corresponds to a continuously-compounded rate, r, in continuous time. We therefore have
R = er∆t .
Remark 3 Recall that the true probability of an up-move, p, has no bearing upon the risk-neutral probability,
q, and therefore it does not directly affect how securities are priced. From our calibration of the binomial model,
we therefore see that µ, which enters the calibration only through p, does not impact security prices. On the
other hand, u and d depend on σ which therefore does impact security prices. This is a recurring theme in
derivatives pricing and we will revisit it when we study continuous-time models.
Remark 4 In the previous remark we stated that p does not directly affect how securities are priced. This
means that if p should suddenly change but S0 , R, u and d remain unchanged, then q, and therefore derivative
prices, would also remain unchanged. This seems very counter-intuitive but an explanation is easily given. In
practice, a change in p would generally cause one or more of S0 , R, u and d to also change. This would in turn
cause q, and therefore derivative prices, to change. We could therefore say that p has an indirect effect on
derivative security prices. This of course is the point we were making when discussing the price of an option on
stocks ABC and XYZ in Section 4.2.
It is more typically the case, however, that we wish to calibrate a binomial model to the risk-neutral dynamics of
a stock following a GBM model. In that case, if the stock has a continuous dividend yield of c so that a
dividend of size cSt dt is paid at time t then the risk-neutral dynamics of the stock can be shown to satisfy
2
/2)s + σ(Bt+s −Bt )
St+s = St e(r−c−σ (16)
where Bt is now a standard Brownian motion under the risk-neutral distribution. The corresponding q for the
binomial model can be obtained from (15) with µ replaced by r − c with u and d unchanged.
10 This calibration becomes more accurate as ∆t → 0. A more accurate calibration for larger values of ∆t can be found in
p p
Luenberger’s text. It takes ln u = σ 2 ∆t + (ν∆t)2 , d = 1/u and p = 1/2 + 1/(2 σ 2 /(ν∆t)2 + 1) where ν := µ − σ 2 /2.
The Effect of Exchange Rate Changes on the Prices and Volume of Foreign Trade (L'effet
des modifications du taux de change sur les prix et le volume du commerce extérieur) (El
efecto de las variaciiones del tipo de cambio sobre los precios y el volumen del comercio
exterior)
Author(s): Mordechai E. Kreinin
Source: Staff Papers (International Monetary Fund), Vol. 24, No. 2 (Jul., 1977), pp. 297-329
Published by: Palgrave Macmillan Journals on behalf of the International Monetary Fund
Stable URL: https://www.jstor.org/stable/3866575
Accessed: 03-03-2020 03:32 UTC

REFERENCES
Linked references are available on JSTOR for this article:
https://www.jstor.org/stable/3866575?seq=1&cid=pdf-reference#references_tab_contents
You may need to log in to JSTOR to access the linked references.

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide
range of content in a trusted digital archive. We use information technology and tools to increase productivity and
facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected].

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at
https://about.jstor.org/terms

International Monetary Fund, Palgrave Macmillan Journals are collaborating with JSTOR
to digitize, preserve and extend access to Staff Papers (International Monetary Fund)

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 The Effect of Exchange Rate
Changes on the Prices and Volume
of Foreign Trade
MORDECHAI E. KREININ *

I. Problem and Conceptual Framework

1. STATEMENT OF THE PROBLEM

ITHIN THE TRADITION of the elasticity approach to the balance of

A payments,1 exchange rate adjustment falls into the general category
of switching policies (in the "old" Johnson sense). Along with tariff
changes and a variety of other measures, exchange variations are
expected to change the relative prices of importables and exportables, and
thereby induce shifts in production and consumption mixes. These
changes, in turn, are expected to restore or to maintain equilibrium in the
balance of payments. But the expected salutary effects of exchange rate
adjustments can occur only if they are fully or partially reflected in the
prices of traded goods, rather than being offset by proportional changes
in domestic prices. The extent to which exchange rate changes are trans-
formed into changes in the prices of imports (denominated in the local
currency) and exports (denominated in foreign currencies) is known as
the "pass-through" effect of the exchange adjustment. Although the

* Mr. Kreinin is a professor of economics at Michigan State University. He

received his doctorate from the University of Michigan, where he also worked
at the Survey Research Center. He has served as a consultant to numerous
national and international agencies, and has been a visiting professor at several
universities.
Most of the work on this paper was done during the author's tenure as a
consultant to the Research Department of the Fund in the summer of 1976. The
U. S. component of the study was financed by a grant from the U. S. Treasury
Department.
1 The received theory of the balance of payments adjustment mechanism con-
sists of a succession of five approaches. See Harry G. Johnson, "Elasticity,
Absorption, Keynesian Multiplier, Keynesian Policy, and Monetary Approaches
to Devaluation Theory: A Simple Geometric Exposition," American Economic
Review, Vol. 66 (June 1976), pp. 448-52.
297

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
298 INTERNATIONAL MONETARY FUND STAFF PAPERS

"monetary" approach (which centers attention on long-run equili

and focuses on the demand for, and the supply of, money as a st
denies that devaluation can have a lasting effect on the balance o
ments, even this approach admits to a transitory change in the term
trade occurring over the short run (without, however, specifyi
short the short run is).
This paper is devoted to an empirical estimation of pass-thro
effects, and is limited to a time horizon of three to four years (
relatively short run). Consequently, this paper belongs in the traditi
the elasticity approach. In that context, the pass-through effe
important implications, both for the balance of payments and f
propagation of inflation. Specifically, the paper estimates the follow
(a) the pass-through effect of exchange rate changes of eight major
rencies under the Smithsonian Agreement of 1971, with a partial inv
tion of the changes occurring in 1973; ;(b) the effect of the abov
changes on the volume of trade flows and the implied import-d
elasticities; and (c) the elasticity of substitution in each of severa
countries as between third country suppliers over two time pe
1970-72 and 1970-73.

2. SOME A PRIORI REASONING

In theoretical, partial equilibrium terms, the pass-through effect

depends on the elasticities of export supply and import demand of the
country and its trading partners. Although these elasticities are known to
vary between countries and over time,2 a few generalizations concerning
the pass-through effect can be made on a priori grounds. A small coun-
try, which can be assumed to face an infinitely (or very highly) elastic
supply of exports from its trading partners, is likely to experience a
nearly complete pass-through on the import side. In turn, only a partia
pass-through can be expected with respect to the import prices of a
large country, which presumably faces upward-sloping export supply

2 See, for example, the following studies: Morris Goldstein and Mohsin S.
Khan, "Large Versus Small Price Changes and the Demand for Imports," Staff
Papers, Vol. 23 (March 1976), pp. 200-25; Hendrik S. Houthakker and Stephen
P. Magee, "Income and Price Elasticities in World Trade," Review of Economics
and Statistics, Vol. 51 (May 1969), pp. 111-25; Mordechai E. Kreinin, "Disag-
gregated Import Demand Functions-Further Results," Southern Economic Jour-
nal, Vol. 40 (July 1973), pp. 19-25, and "Price Elasticities in International Trade,"
Review of Economics and Statistics, Vol. 49 (November 1967), pp. 510-16; and
James E. Price and James B. Thornblade, "U. S. Import Demand Functions
Disaggregated by Country and Commodity," Southern Economic Journal. Vol. 39
(July 1972), pp. 46-57.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 EFFECT OF EXCHANGE RATE CHANGES ON TRADE 299

curves. In other words, such a country can, by its own actions, affect its
terms of trade. The reverse may be the case with respect to the supply
of exports. Here, a large country is likely to have a more elastic export
supply than a small one '(because exports constitute a smaller proportion
of output in most industries in large countries) and is, therefore, less
likely to change export prices denominated in its own currency following
an exchange adjustment. Consequently, exporters in a large country are
likely to pass through a greater proportion of a devaluation or revalua-
tion than exporters in a small country.3
But this argument assumes that the small country specializes in the
export of a few commodities and that it exports a substantial portion of
domestic output of each commodity-an assumption that may be incor-
rect. Viewed from the demand side, the foregoing observations reflect
the fact that a small country is a price taker on the international market,
unable to influence its terms of trade. But this statement leaves open the
question of how large a country has to be before it acquires some control
over its terms of trade, as well as the different degrees of market power
associated with varying economic size. Consequently, the above a priori
statement must be regarded as tentative. In essence, the pass-through
question is an empirical one; it can be handled either through precise
knowledge of the elasticities involved, or by a method specifically
designed to measure the pass-through.
In many empirical studies of the domestic impact of commercial policy
conducted in the 1950s and early 1960s, there was a tendency on the
part of researchers to assume (implicitly or explicitly) a 100 per cent
pass-through. More specifically, it was commonly assumed that changes
in, say, tariffs were fully reflected in changes in import and/or export
prices. In recent years, the pendulum has swung almost completely in
the opposite direction (especially in some theoretical discussions). For
example, in the view of some economists the law of one price ensures
the same price on the world market for each internationally traded good
(including "differentiated" products). Consequently, given sufficient time,
exchange rate adjustments would be fully compensated for by changes in
domestic prices.
Furthermore, during the recent period of fluctuating exchange rates,
the issue has become a key factor in a certain theory that purports to
explain world-wide inflation. While the basic hypothesis involved, the

3 Note, however, that even if domestic export prices rise in full proportion to
the devaluation, there is an inducement to expand exports, since domestic output
expands and consumption contracts with the increase in local currency prices.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
300 INTERNATIONAL MONETARY FUND STAFF PAPERS

Mundell-Laffer (M-L) hypothesis, was developed by (or is attributed t

Professors Robert A. Mundell and Arthur B. Laffer,4 who are also closely
associated with the monetarist approach, the M-L hypothesis is not a
essential ingredient of that approach. Mundell and Laffer assert that not
only do exchange fluctuations fail to equilibrate the balance of payments
but they also contribute to worldwide inflation. The argument runs roughl
as follows: The law of one price guarantees that, given sufficient tim
for adjustment (and abstracting from transport costs), all internationally
traded goods will command the same price everywhere; this applies t
homogeneous and differentiated products alike. Thus, a currency devalua-
tion cannot, over time, change a country's prices relative to those of
competitors; either its prices would rise or foreign prices would decli
until prices were fully equalized internationally. Here, Mundell and
Laffer introduce a second supposition-namely that the price response
exchange rate adjustment is not symmetrical. Export prices (denominated
in local currency) rise in the devaluing country, but import prices fail to
decline in the revaluing one. This asymmetry is often referred to as the
"ratchet effect". As a consequence, the equalization of international prices
is accomplished strictly through price increases in the devaluing country
Since, in a regime of fluctuating exchange rates, some currencies depr
ciate and others appreciate over one time period, while the reverse tends
to occur during some subsequent period, and because domestic price
changes (i.e., increases) occur only in the depreciating countries and n
in the appreciating ones, the net effect is a world-wide increase in t
prices of traded goods.5
Both links in the M-L argument can be questioned. First, there is n
a priori reason for the law of one price to hold in the case of differe
tiated products. Even a brand name can account for a persistent pric
differential. The elasticity of substitution between different suppliers of

4See Mordechai E. Kreinin, International Economics: A Policy Approach

(New York, Second Edition, 1975), pp. 124-25; Arthur B. Laffer, "Do Deval
ations Really Help Trade?" Wall Street Journal (February 5, 1973), p. 10, an
"The Bitter Fruits of Devaluation," Wall Street Journal (January 10, 1974), p. 1
Jude Wanniski, "The Case for Fixed Exchange Rates," Wall Street Journal (Ju
14, 1974), p. 10, and "The Mundell-Laffer Hypothesis-A New View of the
World Economy," Public Interest, Number 39 (Spring 1975), pp. 31-52.
For a more general discussion, see Marina v. N. Whitman, "Global Monetaris
and the Monetary Approach to the Balance of Payments," Brookings Papers
Economic Activity (1975:3), pp. 491-536.
5A further link in the inflation-propagating process-the effect of import pric
on domestic prices-has been examined in Morris Goldstein's "Downward Pri
Inflexibility, Ratchet Effects, and the Inflationary Impact of Import Pri
Changes" (unpublished, International Monetary Fund, April 20, 1977). He fin
that, while import prices do affect domestic prices, there is no clear-cut eviden
that the effect is one-sided-that is, that it works only for price increases a
not for price decreases.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 EFFECT OF EXCHANGE RATE CHANGES ON TRADE 301

manufactured product having similar characteristics is less than infinite

even in the long run.6 And, in any case, it makes a considerable diff
ence whether the period required for price equalization following a cur-
rency devaluation is long or short. If it is very protracted (as implied in
some versions of the M-L hypothesis), then the argument that deva
tion does not improve a country's competitive position holds only in the
long run. Apart from the question of how long the long run is, it i
clear that improvement could occur, and persist, during the years
which the price equalization process takes place. And that may be su
cient for exchange rate adjustments to perform their traditional fu
tion of improving the country's competitive position and its balance
payments.7 By the time the relevant period was over, other exchange ra
changes would undoubtedly occur.
Second, there is no a priori reason to expect a ratchet effect in th
case of exchange rate changes. Even if internal prices are inflexible
a downward direction, import prices (expressed in terms of the ho
currency of a revaluing country) can decline following an upward adjust
ment in the exchange rate. Indeed, empirical studies have shown m
instances of such price reductions, on both a quarterly and an ann
basis, in the postwar period.8
In sum, the pass-through effect of exchange rate adjustment ha
important implications, both for the balance of payments and for
propagation of inflation. But its extent is an empirical question and can-
not be determined by a priori considerations. Such an empirical det
mination is the main purpose of the present study. Since this is ess
tially a short-run investigation, it does not settle the theoretical iss
raised above. Nevertheless, it does shed light on the strength of th
factors over a three-year period.
Since the data available for this investigation are annual and not

6 For a casual observation of this phenomenon, the reader is invited to consult

"Compact Wagons: Volvo, Volare, Peugeot, Toyota," Consumer Reports, Vol. 41
(July 1976), pp. 384-91. Cars that are essentially similar in all characteristics
(i.e., Dodge Aspen and Volvo station wagons) exhibit very large and persistent
price differentials. In large measure, these differentials are caused by exchange
rate changes.
7 See the review of The Monetary Approach to the Balance of Payments, ed.
by Jacob A. Frenkel and Harry G. Johnson (University of Toronto Press, 1976)
(hereinafter this book is referred to as The Monetary Approach) by Gottfried
Haberler in the Journal of Economic Literature, Vol. 14 (December 1976),
pp. 1324-28.
8 See C. Pigott, R. Sweeney, and T. Willett, "Some Aspects of the Behavior
and Effects of Flexible Exchange Rates" (especially Table 10), U. S. Treasury
Discussion Paper (mimeographed, June 1975), and P. Isard, "How Far Can We
Push the Law of the One-Price?" Federal Reserve Board, International Finance
Discussion Paper No. 84 (May 1976).

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
302 INTERNATIONAL MONETARY FUND STAFF PAPERS

quarterly, no time lags were built into the study-that is, it

investigate the lag of price movements behind exchange rate
or the lag of quantity changes behind prices changes. On the oth
because percentage changes in both quantity and price were g
their ratios would yield an elasticity of substitution between sup
each of the countries being studied.

3. METHODOLOGY-A GENERAL DISCUSSION

While other students of the subject have employed econometric

models 9 to examine the question at hand, this study relies on a "control
country" approach designed specifically for this purpose. In a sense, this
approach fulfills the role of a laboratory experiment or an economic
model in "holding other things constant." For, in any given year, a mul-
titude of factors affect the import and export prices of a country. Yet, in
estimating the pass-through effect, it is necesary to isolate the impact of
exchange rate changes on the prices of traded goods (as well as on the
volume of trade). In other words, the pass-through effect is the difference
between the change in prices that actually has taken place and the hypo-
thetical change that would have occurred in the absence of exchange rate
changes (but with all other influences allowed to have their full impact).
The problem is to obtain the hypothetical change. The approach
employed here uses a control country (or countries) to arrive at that
change. Ideally, such a country should be similar in all or most respects
to the country with which the control country is being compared, except
that its exchange rate did not change. Because such an ideal is rarely,
if ever, found in practice, we shall use several (usually three or four)
control countries for each country under study. (Additionally, we shall
examine the nature of possible biases and develop alternative formulas to
deal with them.) In each case, the hypothetical price changes in the
investigated country are inferred from the average change that actually
occurred in the control countries. The control country (countries) vary

9 Consult, for example, S. Y. Kwack, "Price Linkages in an Interdependent

World Economy: Price Responses to Exchange Rate and Activity Changes,"
Federal Reserve Board, International Finance Discussion Paper No. 50 (Janu-
ary 3, 1975); Stephen P. Magee, "Currency Contracts, Pass-through and Devalua-
tion," Brookings Papers on Economic Activity (1973:1), pp. 300-25; Peter Clark,
"The Effect of Exchange Rate Changes on the U. S. Trade Balance," Federal
Reserve Board, International Finance Discussion Paper No. 52 (September 9, 1974)
(hereinafter referred to as Clark, "Effect of Exchange Rate Changes").
Also, see The International Linkage of National Economic Models, ed. by
Robert J. Ball (Amsterdam, 1973), and The Models of Project LINK, ed. by
Jean L. Waelbroeck (Amsterdam, 1976).

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 EFFECT OF EXCHANGE RATE CHANGES ON TRADE 303

from one investigated country to another. They are selected in each

so as to best hold "other things" (i.e., variables other than the excha
rate changes) constant, and to isolate the effect of exchange rate change
A detailed description of the estimating procedures is offered in
next section.
It is not claimed that the control country approach is better (or, f
that matter, worse) than alternative methods used to investigate the sam
problem; only that it is different. When an issue is sufficiently import
then-given the well-known possibility of errors in any empirical invest
gation-it is desirable to employ as many approaches as possible to
investigate it. Similar results yielded by diverse methods would add con-
fidence to the estimates.
Although the control country (or, alternatively, a control product group)
approach is not often used in international economics, it has been
employed on several occasions, and by now has acquired a respectable
tradition in the field. Its use was originally stimulated by Orcutt's seminal
article on elasticity measurement,1' in which he demonstrated the strong
downward bias imparted by the traditional regression model and urged
the use of alternative methods. Since that time the control country or
control group approach has been employed to deal with such problems
as the effect of tariff changes on trade flows; trade and colonialism; the
effect of tariff concessions on the exports of developing countries; and
the effect of regional economic integration on the volume of imports."1
In all these cases the control country approach yielded fruitful results.
It has certainly proved robust enough to warrant its application to the
present problem.

10 Guy H. Orcutt, "Measurement of Price Elasticities in International Trade,"

Review of Economics and Statistics, Vol. 32 (May 1950), pp. 117-32, reprinted
in Readings in International Economics, ed. by Richard E. Caves and Harry G.
Johnson (Homewood, Illinois, 1968), pp. 528-52.
11 Following are examples of studies which used this estimation technique:
J. M. Finger, "GATT Tariff Concessions and the Exports of Developing Coun-
tries-United States Concessions at the Dillon Round," Economic Journal, Vol. 84
(September 1974), pp. 566-75, and "Effects of the Kennedy Round Tariff Con-
cessions on the Exports of Developing Countries," Economic Journal, Vol. 86
(March 1976), pp. 87-95; E. Kleiman, "Trade and the Decline of Colonial-
ism," Economic Journal, Vol. 86 (September 1976), pp. 459-80; Lawrence B.
Krause, "United States Imports and the Tariff," American Economic Review,
Papers and Proceedings, Vol. 49 (May 1959), pp. 542-51; Mordechai E. Kreinin,
"Effect of Tariff Changes on the Prices and Volume of Imports," American
Economic Review, Vol. 51 (June 1961), pp. 310-24 (hereinafter referred to as
Kreinin, "Effect of Tariff Changes"), and "Effects of the EEC on Imports of
Manufactures," Economic Journal, Vol. 82 (September 1972), pp. 897-920, and
"A Further Note on the Elasticity of Substitution," Canadian Journal of Eco-
nomics, Vol. 6 (November 1973), pp. 606-608 (hereinafter referred to as Kreinin,
"A Further Note").

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
304 INTERNATIONAL MONETARY FUND STAFF PAPERS

II. Approach and Estimation Formulas

1. THE USE OF CONTROL COUNTRIES

Under the 1971 Smithsonian Agreement, there was a realignment of

all major currencies. The exact change in the exchange rate of a given
currency depends on the weight assigned to each of that country's trad-
ing partners. Various indices have been constructed 12 to estimate the
average changes in the exchange rate of each major currency. These
indices, which generally employ 1970 as a base period, were developed
for use in the period of fluctuating exchange rates. They differ from each
other in the nature of the weights assigned to each bilateral change in
the particular currency's exchange value.13 Regardless of the weighting
scheme, the indices show the following (approximate) exchange rate
changes of major currencies between 1970 and 1972: U. S. dollar
-10 per cent; Japanese yen + 15 per cent; deutsche mark +6 per cent;
and French franc unchanged. Similar averages are available for other
currencies of the industrial countries. Most empirical investigations of
the effects of exchange rate changes utilize these average changes.
In contrast, the present study makes use of the fact that the average
change in the value of each currency is made up of differential degrees of
bilateral changes vis-a-vis different individual currencies. For example,
various currencies were revalued by different amounts relative to the
U.S. dollar in the Smithsonian Agreement of 1971. The Smithsonian
changes approximated the changes in exchange rates that took place
between (average) 1970 and (average) 1972. But because other adjustments
have occurred in the value of some currencies, the two sets of changes
are not identical. Table 1 shows the average 1972 exchange rate changes,
relative to the dollar, of 15 main countries of the Organization for Eco-
nomic Cooperation and Development (OECD). For the sake of con-
sistency with subsequent computations, mean dollar exchange rates in 1970

and 1972 i.e., + rl were used as a base in computing the

(percentage) exchange rate variations.
Our interest lies in estimating the pass-through effects of these
exchange rate changes. In order to illustrate the method employed, we

12 See Rudolf R. Rhomberg, "Indices of Effective Exchange Rates," Staff

Papers, Vol. 23 (March 1976), pp. 88-112.
13 The main types of weights used are bilateral trade (imports, exports, or an
average of the two) weights, global export weights, and weights derived from a
special Fund model (known as the multilateral exchange rate model, or MERM)
that are designed specifically to measure the effect of exchange rate changes on
the country's balance of trade.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 EFFECT OF EXCHANGE RATE CHANGES ON TRADE 305

TABLE 1. SIXTEEN OECD COUNTRIES: PERCENTAGE CHANGES IN U.S. DOLLAR

EXCHANGE RATES, 1970-72, AND INDICES OF INDUSTRIAL PRODUCTION AND OF
CONSUMER PRICES, 1972

Percentage 1972 1972

Change in Index of Consumer
U.S. Dollar Industrial Price
Exchange Rate Production Index
Country (1970-72) (1970=100) (1970= 100)
Australia 7 108 112
Austria 11 114 111
Belgium 12 109 110
Canada 5 113 108
Denmark 8 111 112
Finland 1 114 114
France 9 112 112
Germany, Fed. Rep. 13 106 111
Italy 7 104 111
Japan 17 110 111
Netherlands 12 111 116
Norway 8 110 114
Sweden 9 104 109
Switzerland 12 104 114
United Kingdom 4 102 117
United States - 108 108
Sources: Exchange rate change
Vol. 59 (January 1973), p. A93.
for Economic Cooperation an
(August 1975). Indices of indu
Monthly Bulletin of Statistics,

begin by using the Unite

effect did the dollar deva
tities) of U. S. imports an
tries revalued its currency
Corresponding to each exc
the dollar prices of U. S. im
U. S. exports to, the part
(bilateral) price changes ca
Caused by general inflation,
tors, they would have occ
of the exchange adjustmen
tion on foreign trade pric
change that would have oc
hypothetical and the actu
adjustment on foreign trad
The control country app
price change for each rev
Finland and Norway are id
bundle of goods they expo

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
306 INTERNATIONAL MONETARY FUND STAFF PAPERS

revalued by 8 per cent relative to the dollar between 1970 and 1972,
while Finland did not change its dollar exchange rate. If the U.S.
(dollar-denominated) import price index from Norway increased 16 per
cent, while that from Finland increased 14 per cent, the effect of Nor-
way's revaluation on its dollar export prices to the United States is taken
to be (16 per cent - 14 per cent =) 2 per cent, and its pass-through effect
on U. S. imports is then (2 - 8 =) 25 per cent. It other words, the export
price change of Finland (the control, or c, country) is used as a proxy for
the hypothetical price change of Norway (the i country in which follows)
in the absence of revaluation. Schematically (with all figures representing
percentages):
Estimated
Norway Finland Differential Pass-Through
ERJ +8 0 8
p-.s. +16 +14 2
where EsR is the percentage chan
1970 and 1972, and pv..' is the pe
from each country over the sam
follow, the country under investig
will be referred to as the K countr
such countries. In the study of eac
tries (the criteria used for their se
to 11 i countries (defined as all cou
that trade with the K country),
estimated pass-through of the K
tions, with the averaging procedur

2. BASIC ESTIMATION FORMULA FOR BILATERAL IMPORT PASS-THROUGH

For greater generality, we introduce the following notation: iERK and

cEJK are the 1970-72 percentage changes in the exchange rates of the i
and the c countries, respectively, relative to country K. These exchange
rates are defined as units of the K currency per unit of the i or c currency.
For example, if K is the United States, the expressions refer to dollar
exchange rates, defined as cents per unit of foreign currency. (In what
follows, we shall use the U.S. as an example of the K country whenever
an example is needed for the purpose of clear exposition.) /iK; .PK are
the 1970-72 percentage changes in the prices of the K country's imports
from the c and the i countries, respectively (on products imported into
country K from both c and i countries). Px and Pd refer to the 1970-72
percentage changes in export prices and domestic prices, respectively.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 EFFECT OF EXCHANGE RATE CHANGES ON TRADE 307

For any country K whose currency was devalued with respect to coun-
try i:

iPM (1)

That is,
country
relative
P/I as a
rate adju
estimated as:
pK _ pK
a= 100 (2)

In all calculatio
average 1970 t
price levels in
cluded in each
i countries ar
matching don
But this proce
are unaffected
rise in p/ Kwo
from country
Although this
short time spa
lation must, th
through effec
trol country,
Equation (2) i
pass-through.
9 to 11 i coun
The import p
will be discuss
dwell on vario
well as alternative formulas.

3. BIASES, ADJUSTMENTS, AND ALTERNATIVE FORMULAS

In essence, then, the control country represents developments that

affect the prices of the i country's exports to the K country in the absence

14 In Section IV.2, the substitution elasticities are estimated at between -0.5

and - 1.8.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
308 INTERNATIONAL MONETARY FUND STAFF PAPERS

of revaluation. In addition to being an important trading par

country, the "ideal" control country (or countries) should
conditions: its exchange rate relative to the K country sh
unchanged; and it (they) should adequately represent econ
tions in the i countries. In particular, the control countr
should-on the average-experience the same rate of growth and of
domestic inflation as the i countries over the period being considered.
It is not always possible to find control countries that meet these condi-
tions.
Starting with the first condition and using the United States as an
example of a K country, it may be seen in Table 1 that each of the 15
countries revalued to some degree against the dollar. As a consequence,
it was necessary to select as control countries those that revalued least.
This led to the selection of Finland, Canada, and the United Kingdom.15
Each was used separately to estimate the pass-through of a revaluation
of each of the 12 other countries, yielding 36 ai bilateral observations.
But the use (as a control) of a country that revalued against the dollar
requires the introduction of two alternative assumptions, with the results
establishing lower-bound and upper-bound estimates of the pass-through
effect.
Consider the following illustrative scheme with respect to the dollar
exchange rates:

Germany, Fed. Rep. United Kingdom

ER$ 13 4
pius. 16 12

Under the fir

increase was
rise would hav
Republic of G

is 12 per ce
cent. This is t
ber subtracted
mate should
change adjustm
bound estimate is to the true estimate. As a second alternative, assume

15 None of the three countries is "ideal." Thus, Finland's exports are highly
specialized, while the United Kingdom suffers from perennial domestic problems.
Therefore, only average results are presented. These were later verified using Italy
as a control country.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 EFFECT OF EXCHANGE RATE CHANGES ON TRADE 309

that the control country (the United Kingdom) experienced a 100 per cent
pass-through. Then only 8 (12 - 4) per cent of the U. K. price rise would
have occurred in the absence of a sterling revaluation. The German pass-

through is then estimated at 1 = 61 per cent. This is a reason-

able assumption to generate the upper-bound (ai,) estimate

a iP - (= ' ? CE)* 100 (3)

As the revaluation of the con

approaches zero, the lower an
downward bias-inherent in th
viously), the actual estimate
the lower bound.
While the selection of cont
stability of their exchange r
condition requires that "on t
i countries with which they
selecting several (rather than
results. However, whenever t
inflation rates of the c count
deemed necessary.
Specifically, the change in the
of the change in its exchange

P = f (ERK, Pd)

Since our interest centers on the effect of the exchange rate, we wish to
hold constant the impact of domestic inflation. But Pd may be different in
the control and the i country. To account for the difference, the price index
of K country imports from the control country was adjusted in each com-
parison (with an i country) by the difference between the two countries'
1972 domestic prive indices (1970= 100).

P K, adjusted = P - (Pd - Pd) (4)

where iPd and cPd are the domestic price indices of the i
respectively. An ideal index for this purpose would be

16 When the United States is the country being investigated

average 1972 consumer price index of the three control coun
Kingdom, Finland, and Canada) was 113. This compares with an
for the 12 i countries, and of 112 for the 15 countries combined.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
310 INTERNATIONAL MONETARY FUND STAFF PAPERS

all potentially traded goods but excluded imports. However, si

an index was not available, the consumer price index was emp
The assumptions underlying this adjustment are that domesti
changes are fully reflected in the prices of export goods, and that
of exchange adjustment is superimposed upon them. Although
somewhat unrealistic, the bias introduced by these assumptions is
rather small, for the following reasons: first, because the dis
between domestic prices and export prices is likely to be similar i
countries; and second, because the differences between iPd and
therefore, the adjustments themselves) are usually small. In ot
the control countries were usually representative of the i coun
respect to their domestic rates of inflation (as well as their grow
Equation (4) was inserted appropriately into equations (2) and
generate estimates adjusted for differential inflation rates. Bu
cases, these did not differ from the unadjusted figures.

4. ESTIMATION FORMULAS FOR BILATERAL EXPORT PASS-THROUGH

A symmetrical analysis was undertaken with respect to exports. Again

using the United States as the K country in a schematic illustration,
sume that U. S. export prices (PU.S.) of identical bundles of goods destine
for the control country and the i countries changed as follows from 197
to 1972:
i Country c Country
ER$ 10 0
PuhS. +12 +8
Following the previo
country caused U. S. export prices to rise by (12 - 8 =) 4 per cent.
Thus, (4 . 10 =) 40 per cent of the revaluation was absorbed by a
rise in U. S. dollar export prices, and the pass-through effect is esti-
mated at 60 per cent. More generally, the pass-through effect of the
i country's revaluation relative to the K country is estimated from the
following equation:

at, = 100- p X * 100 (5)

jERK
As in the case of imports, a downward bias is introduced into cPX because

17 Unfortunately, the consumer price index contains many nontraded goods

and services on the one hand, and imported commodities on the other. However,
an index of producers' prices of manufactured goods or an index of unit labor
costs in manufacturing (the latter index is of questionable reliability, and is also
one step removed from the price index) were available only for some countries.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 EFFECT OF EXCHANGE RATE CHANGES ON TRADE 311

of substitution in demand for K country products from the cont

country to the i country. The resulting estimate must be regarde
lower bound.
When the control country experiences a revaluation relative to the K
country, equation (5) becomes the upper-bound estimate, while the lower-
bound estimate is given by:

,iRK ) 100 (6)

As in the case of imports, a price adjus
the change in the prices of the i country
in the prices of the K country's exports t
the change in the exchange rate, as well as
in the i country. In employing the contr
hold the second factor constant, so as to concentrate on the first. Con-
sequently, similar price adjustments were introduced into equations (5)
and (6) as in the case of imports; that is, the CPK was adjusted upward
by cPd - iPd.

5. AVERAGING OF BILATERAL ai OBSERVATIONS FOR EACH K COUNTRY

No restrictions are imposed on the individual comparisons; only aver-

age results of all bilateral i country observations for each K country are
relied upon in arriving at the estimated pass-through. In addition to
unweighted averages, a weighted average was calculated in two steps.
First, an unweighted mean of each ao estimate (generated by the three
to five control countries) was computed for each of the i countries. These
were then averaged by assigning each i country a weight proportional to
the K country's imports from it (or export to it) in 1970 and 1972. We
have

ai iMM70+72
a = M for imports (MK represents imports of K)
E M70+72

E ai ? iX70+72
a = X fK for exports (XK represents exports of K)
70+72

Yet another method of averaging the individual oa observations is

estimating a weighted regression of the form

P = a + b ER

where P represents the differential percentage price change between the

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
312 INTERNATIONAL MONETARY FUND STAFF PAPERS

and the control country (,PK - P K), ER is the percentage exch

change of the i country relative to the K country, and where the
rate change of the control country is zero. Each observation is
by the shares of the i countries and the control countries in the p
imports of the country K under study. Thus, in Figure 1, pl
against ER, the 45 degree line represents a 100 per cent imp
through (i.e., the change in import prices equals the change in
change rate) and the regression line shows deviations from this
Plugging the change in the effective exchange rate of the K c
into the estimated equation yields an estimate of the pass-thro
To illustrate this method, consider the resulting equation for
imports

P = -2.17 + 0.92 ER

'K *K
M cM 5?

/ REGRESS

0 /
EFFECTIVE EXCHANGE ERK
RATE CHANGE

Figure 1

18A shortcoming of this method in the present context is that the effective
exchange rate index is computed for country K relative to all currencies-the
control currencies as well as the i currencies-while the regression line is esti-
mated on the basis of the relation of country K's currency to the (adjusted)
i country currencies only.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 EFFECT OF EXCHANGE RATE CHANGES ON TRADE 313

when ER = 15 per cent, P = 11.63, and the pass-through is estimat

at (11.63 - 15 =) 77.5 per cent. Similarly, for the United States, this
method yielded an import pass-through of between 35 per cent (lower
bound) and 70 per cent (upper bound) and an export 19 pass-through of
100 per cent.
In most cases, the various methods of arriving at the estimate yielded
similar (though not identical) results. Consequently, after several alter-
native estimates are discussed for the United States, only one (best) esti-
mate will be presented for each of the other countries.

6. ESTIMATION OF TRADE VOLUME AND ELASTICITIES

With respect to the quantity Q of trade, the control country approach

suggests that the percentage change in the K country's imports from
(exports to) the control country (whose exchange rate relative to the K
country did not change) serves as a proxy for the percentage change in
the K country's imports from (exports to) the i country in the absence of
exchange rate adjustment. The estimated effects of an i country revalua-
tion on the K country's imports from, and exports to, the i country would
thei be (respectively):

Q - Q and (7)
QK- K (8)
These would t
average as ind
substitution bet
tions of its exp
mates must be
Implied in the
demand elastic
demand for eac
Finally, the d
substitution b
market. In mo
observations
between 1970
pertains to a co
pair. A regres

19 On the expor
tion) absorbed b
pass-through.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
314 INTERNATIONAL MONETARY FUND STAFF PAPERS

both in percentage terms-would yield an estimate of the elasticity o

substitution in each K country market. The specific form of the regres-
sion is:

In Qt/Qj = a + b In (Pg/Pj)
for each pair of suppliers i and j (covering matched products), wher
is the estimated elasticity.

III. Data and Computational Procedures

1. PERIOD COVERED

All observations employed in this paper relate to percentage changes

between 1970 and 1972. These two years are well suited for this study's
purposes. The economies of all OECD countries were on a steady expan-
sion path, with the indices of industrial production (1970 = 100) of most
European countries and Japan in the 105-112 range in 1972. Domestic
prices of the OECD countries advanced at a roughly similar and rela-
tively moderate pace. With 1970 equal to 100, the consumer price
indices of most industrial countries were in the 108-113 range in 1972,
although greater variations were exhibited in their indices of unit labor
costs in manufacturing.20 For some of the countries these indices show a
quantum jump in 1973; in all countries, an even greater jump occurred
in 1974, the year of double digit world-wide inflation. This behavior is
also evident in the export and import price indices. The point of this
discussion is that in 1970-72, and to some (but a lesser) extent in
1970-73, the exchange rate adjustments were major developments, whose
effect was unlikely to be swamped by that of the other price changes. The
same can hardly be said of 1970-74. The 1970-72 comparison is there-
fore considered reliable.

2. DATA SOURCES

Because the study focuses on the behavior of unit value and quantity
(or volume 21), it requires the use of a set of commodity trade statistics

20 Consumer price indices are available in the OECD, Main Economic Indi-
cators (various issues). For some countries, the wholesale price index and the
index of producers' prices of manufactured goods are given in the same publica-
tion. Indices of unit labor costs in manufacturing for ten countries were compiled
and supplied privately by the Bureau of Labor Statistics, U. S. Department
of Labor.
21 The words quantity and volume are used interchangeably in this study. Unit
value is value divided by volume; it is used as the only available (albeit imper-
fect) proxy for price.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 EFFECT OF EXCHANGE RATE CHANGES ON TRADE 315

that are as disaggregated as possible. Only high disaggregated products

homogeneous enough for the quantity information to be meaningful. F
the United States (as the K country), this study draws on the U. S. Trea
ury's Trade Statistics U.S.A. data tapes for 1970 and 1972. Based on t
seven-digit Schedule A (import) and Schedule B (export) classificatio
they include value and volume data for individual products importe
and exported from, the United States by source country and destinatio
country, respectively. For all other countries, the somewhat more aggr
gated (four-digit or five-digit Standard International Trade Classificatio
(SITC) of commodities) OECD trade data tapes were used as the primary
data source. To check on the comparability of the data, the pass-through
effect of U. S. imports was estimated twice in the same manner using
both sets of data. The results weYe, indeed, very similar: in the 35-65 per
cent range using the U. S. census data, and in the 40-70 per cent range
using the OECD data.

3. COMPUTATIONAL PROCEDURES

Unit values (value- volume) were calculated for every commodity

imported into (exported by) the K country from (to) each of the industrial
countries show in Table 1 except Australia (which was included only
when the United States was designated the K country) for the years
1970 and 1972. These countries account for most of world trade in manu-
factured products. Trade flows that contained no volume information (pri-
marily because even the five-digit or seven-digit product was too hetero-
geneous) were rejected-that is, not included in the study. Next, the
changes from 1970 to 1972 22 in (a) volume (or quantity) and (b) unit
value were computed for every trade flow. Each change was then con-
verted into a percentage change, using the average of 1970 and 1972 as a
base.23 All subsequent computations involving averaging and aggregation
relate strictly to these percentages. The objective was to obtain paired
source countries (for K country imports) and paired destination countries
(for K country exports) for comparisons of average percentage changes in
unit values and quantities that in each case covered only those products
that were exported by (or to) both countries in the pair. This made com-
parisons possible between each i country and each control country with a

22 Specifically, 1972 minus 1970, taking note of negative signs.

23 For any given trade flows, the quantity Q and unit value UV formulas are,
respectively:

(Q1972 - Q1970) * 2 (UV1972 - UV1970) 2 2

Q1972 + Q1970 UV1972 + UV1970

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
316 INTERNATIONAL MONETARY FUND STAFF PAPERS

commodity bundle common to both of them. The procedure is best

described by the use of one illustration-U. S. (the K country) imports
from the pair of source countries made up of Canada and the Federal
Republic of Germany.
All disaggregated U. S. imports from both countries in the pair were
matched by their seven-digit number. Commodities not imported from
both countries were excluded from the comparison. For the accepted
products (i.e., those imported into the United States from both source
countries in 1970 and 1972), an average percentage change in unit value
and volume was calculated over all commodities. In calculating the aver-
age for each country, the value of U. S. imports of that product (from the
country) in the two years combined was used as a weight:

E (%AUVGer X ValueGe6+1972)
all

FED. REP. OF GERMANY commodities

Unit Value ValueG+r.72
all
commodities

E (%A QGer'X Value1970+1972)

all
Index commodities
FED. REP. OF GERMANY = commodities
Quantity GValueGer
E Value1970 +1972
all
commodities

Similar indices were calculated for Canada.24

A similar procedure was followed for each pair of source countries of
U. S. imports. However, the commodity coverage differed between pairs,
because in each case only products exported by both countries in the pair
were included. Paired comparisons of quantity and unit values were also
made for U. S. exports, with respect to the countries of destination. The
same procedure was followed with respect to the trade of each K coun-
try. However, for the United States (only), in addition to averages cover-
ing all commodities, averages pertaining to all manufactures (SITC 5-8),
and to certain groups of manufactures were calculated. It is to these aver-
age percentage changes that the formulas developed in Section II apply.

IV. Results

1. PASS-THROUGH EFFECT

Of the 15 countries for which indices of changes in price and quanti-

ties were computed, France, Denmark, Norway, and Sweden experienced

24 Negative changes in either quantity or unit value were taken into account.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 EFFECT OF EXCHANGE RATE CHANGES ON TRADE 317

either no change or only minor changes in their effective exchange rat

between 1970 and 1972. Since some of the remaining countries wer
"used up" as control countries, estimates were prepared for eight in
trial countries-the six countries appearing in Tables 2 and 3, plus t
small countries discussed in the text. In selecting the countries to
studied, an attempt was made to include countries of different sizes
terms of their gross national products and international trade volum
and consequently of varying degrees of monopoly power on the interna
tional market. Table 3 presents several estimates for the United St
(in addition to a regression-generated result mentioned in Section 1
while Table 2 presents the "best" estimates for six countries. As ca
seen in the second column of Table 2, the control countries differ
for each country investigated. Generally speaking, the results display a
measure of consistency regardless of which combination of control coun-
tries (out of those listed in each case) is used. In order to avoid an
impression of undue precision, all pass-through estimates were rounded
to the nearest 5 per cent. With two exceptions (listed in footnote 3 of
Table 2), the estimates correspond well to theoretical expectations.
We start with the estimated pass-through in the United States that is
shown in Table 3 and in the first row of Table 2. While the estimates
vary, depending on the commodity coverage and on the weighing proce-
dure used in calculating the averages, the figures do impart a distinct
impression. For U. S. imports, the pass-through effect is between 30 and
55 per cent (somewhat less than that for imports of chemicals). Consid-
ering the downward bias imparted to these figures by the control country
estimating procedure, the actual estimate is probably close to (somewhat
less than) one half. Foreign exporters absorbed over one half of the dollar
devaluation by lowering their export prices. Thus, if the effective exchange
devaluation of the dollar was about 10 per cent,25 then U. S. import prices
increased by nearly 5 percentage points, while foreign export prices
declined by more than 5 percentage points.
This is a relatively short-run estimate, where the period of adjustment
allowed for is less than a year. The estimate is reasonably consistent with
earlier findings concerning the effect of U. S. tariff reductions,26 and used
a similar methodology. It suggests that, at least in the short-run, the U. S.
import demand curve is roughly similar in slope to the foreign export
supply curve facing the United States.
In the case of U. S. exports, the estimates leave an unmistakable impres-
sion (again, without attaching undue significance to any individual figure)

25 See Rhomberg, op. cit.

26 See Kreinin, "Effect of Tariff Changes" (cited in footnote 11).

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 TABLE 2. Six INDUSTRIAL COUNTRIES: ESTIMATED EFFECTS OF EXCHANGE RATE ADJUSTMENT ON TR
Value of
Trade With Percentage
Industrial Change in
Direction Countries Estimated Effective C
K Control of (average for Pass- Exchange Terms of
Country Countries Trade 1970-72) Through 1 Rate Tr
Billion U. S.
dollars X Per cent
United States Canada Imports 32 50 -1
United Kingdom Exports 28
Finland

Germany, Fed. Rep. Belgium, Nether- Imports 25 6

lands, Switzer- Exports 30 902 + +3
land, Austria ef
Japan3 Germany, Fed. Rep. Imports 9
Belgium Exports 11 85 15 +9
Switzerland
Canada United Kingdom Imports 14
Italy Exports 16 60 +6 +
Belgium Austria Imports 11 90
Netherlands Exports 12 75 3 +2 d
Switzerland ef

Italy France, Denmark, Imports 11 100

Norway, Sweden Exports 11 1002 d

1 A pass-through on the import side is defined as the percentage of the devaluation (revaluation) translated
in domestic prices. On the export side, it is defined as the percentage of the devaluation (revaluation) translate
in foreign import prices from the country under study, or 100 per cent minus the percentage change in that country's
2 Figure appears to be unduly high.
3 Volume and estimated elasticity of import demand are biased downward.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 EFFECT OF EXCHANGE RATE CHANGES ON TRADE 319

TABLE 3. UNITED STATES: ESTIMATED PERCENTAGE PASS-THROUGH OF DOLLAR

DEVALUATION FOR IMPORTS AND EXPORTS, 1970-72

Unweighted Weighted Selected Country

Mean Average Weighted Average
Price
Commodity Adjust- Lower Upper Lower Upper Lower Upper
Group ment bound bound bound bound bound bound

Imports

All commodities Yes 20 55 35 65 30 60

No ... ... 25 50 15 35
SITCs 5-82 Yes 20 50 30 55 30 55
No ... 30 55 0 25
SITC 5 No ... ... 20 50
SITC 7 No ... ... 25 55

Exports

All commodities Yes 70 100 85 110 80 100

No ... ... 95 125 90 115
SITCs 5-8 Yes 80 110 90 115 95 120
SITC 5 No ... ... 85 105
SITC 7 No ... ... 105 125

I Uses the United Kingdom as co

the small i countries; and Canada
2 SITC denotes Standard International Trade Classification.

that the devaluation pass-through was complete or nearly so.27 In other

words, U. S. exporters failed to raise their dollar prices as a result of the
devaluation; foreign currency prices of U. S. exports declined in propor-
tion to the dollar devaluation. This estimate is consistent with an infinitely
elastic (or nearly so) U. S. export supply curve which could result, at least
in part, from the small share of exports in the total output of most
U. S. industries. In sum, it appears that, in the short run, the U. S.
commodity terms of trade deteriorated by about half the proportion of
dollar devaluation, or by roughly 5 per cent.
Besides the United States, the Federal Republic of Germany and (to a
lesser extent) Japan appear to be "price makers" on the buying side of the
international market, with pass-through effects on the import side of 60

27 The results for the United States were checked by rerunning the estimates
using Italy as a control country. The estimates so generated closely approximate
the results shown in Table 2.
Also, the U. S. estimates conform to the results obtained for the floating
exchange rate period, using a distributed lag model, in Clark, "Effect of Exchange
Rate Changes" (cited in footnote 9), and to the estimates derived by Jacques
R. Artus in his paper, "The Behavior of Export Prices for Manufactures," Staff
Papers, Vol. 21 (November 1974), pp. 583-604.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
320 INTERNATIONAL MONETARY FUND STAFF PAPERS

and 80 per cent for Germany and Japan, respectively.2' For the remai
three countries in Table 2, the import pass-through rises to betwee
and 100 per cent. Not reported in the table are estimates for Austria a
Switzerland, each of which show 100 per cent import pass-through. Th
results conform to theoretical expectations in terms of their absolute
they conform especially well in terms of the country ranking.
On the export side, the estimated pass-through ranges from 60-
per cent. The export pass-through appears to be invariably on the
side, meaning that export prices expressed in domestic currencies did
change much. For the Federal Republic of Germany and Italy, the resu
appear to be unduly high, and to contain a possible upward bias. T
estimates for Canada undoubtedly reflect the importance of the U
States as a trading partner of Canada, for they are nearly a mirror im
of the U. S. results.
By applying the pass-through estimates in Table 2 to the respec
changes in the effective exchange rates, we obtain the changes in the te
of trade of each country owing to the exchange adjustment. The la
positive impact occurred in Japan, while the largest negative effect to
place in the United States. In sum, within the three-year time span un
consideration, the estimates support the traditional view that (whe
product of the supply elasticities exceeds the product of the dem
elasticities) devaluation worsens a country's terms of trade, while reva
ation improves them.
These results cast doubt on the strength of the so-called ratchet eff
Foreign exporters to the United States met the revaluation of their cu
rencies by lowering their export prices by more than half the revalua
more than matching the increase in import prices in the devaluing coun
Conversely, exporters to the Federal Republic of Germany (and,
lesser extent, to Japan) raised their prices by only 40 per cent of
German revaluation.
Similarly, U. S. export prices, expressed in foreign currencies, declin
roughly in proportion to the U. S. devaluation,29 while Japanes
Canadian export prices rose proportionately less than their revalua
Nor is there support for the M-L argument that domestic price incre
would fully erode any competitive gain from devaluation, or that cur
devaluations constitute the main force propelling the worldwide infla

28 Highly tentative estimates for the United Kingdom yield results simil
those obtained for Japan.
29 For evidence that such declines can also lower domestic prices in the im
ing countries, consult Goldstein, op. cit.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 EFFECT OF EXCHANGE RATE CHANGES ON TRADE 321

On that latter point, additional (though highly tentative) evidence

gleaned from the data. The general impression one receives is
domestic price movements in the countries of destination influ
pricing policies of foreign exporters.
Export prices of any exporting country tended to rise more, or d
less, in countries of destination that were plagued by relatively hig
tion, than in countries with a relatively stable price level, where
local competition was presumably stiffer. This suggests that the interna-
tional transmission of inflation following exchange rate adjustments
depends on domestic inflationary pressures in the importing countries,
rather than the converse. However, it should be stressed that this is a
short-run analysis, whereas the thesis attributed to Mundell and Laffer
(as well as the monetary approach to the balance of payments) is said to
hold only in the long run.

2. TRADE VOLUME AND ELASTICITIES

A marked effect on the volume of trade was observed in three of the

six countries investigated. For Belgium and Italy, the small size of the
exchange adjustment may account for the absence of change in volume,
but for the Federal Republic of Germany, the explanation must be sought
elsewhere. In the remaining three countries, the results conformed to
theoretical expectations. For the United States, imports are estimated to
have decreased by 10 per cent and exports to have increased by 17 per
cent as a result of the devaluation. Given a 10 per cent dollar devaluation
and a 50 per cent pass-through on the import side, this yields a U. S.
import demand elasticity of (10 5 =) 2.30 With a 100 per cent pass-
through on the export side, the estimated foreign elasticity of demand for
U. S. exports is 1.7. Similarly, the import demand elasticities are 1.25 and
2.5 for Japan and Canada, respectively, while the foreign demands for
their exports have elasticities of 1.1 and 2.3, respectively. Not shown in
the table are estimated elasticities of Austria's demand for imports of
-0.9, and of foreign demand for Austria's exports of -3.5. Finally, it
should be noted that the volume results for Japan, and therefore the
implied elasticity of demand, are strongly biased downward because the
control countries devalued by 4 to 5 per cent relative to the yen.
Most elasticities generated by exchange rate changes may be lower than
tariff elasticities, because traders may consider exchange rate changes
reversible in making their pricing decisions, while the General Agree-

30 For manufactured products (SITCs 5-8), the estimated elasticity is 4.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
322 INTERNATIONAL MONETARY FUND STAFF PAPERS

ment on Tariffs and Trade rules make tariff changes irreversibl

most part. However, most volume changes shown here are of
magnitude to meet the Marshall-Lerner stability conditions.
Corresponding to the calculation of the average differentia
(1970-72) in unit values of each K country's imports from pairs
countries is a similar calculation of the differential percentage c
the volume of imports from the same pair over the same period
an identical bundle of goods. Since changes in K country inco
domestic prices can be assumed to affect both source countri
same degree, the differential change in quantity is attributab
differential change in foreign prices.
For U. S. imports, the linear regression (of percentage change
differentials on percentage change price differentials) fitted to
observations is

Q = -0.667 - 1.813 P R2 = 0.659

(-0.484)(-8.786) D-W = 2.121
where the figures in parenthesis represent t-statisti
coefficient and its level of significance (as well
coefficient) remain virtually unchanged if each obs
the share of U. S. imports from all industrial countr
The elasticity of substitution in the U. S. market
thus estimated to be -1.8. This result correspond
elasticity estimates arrived at by other methods
short (are about half the size) of estimated long-run elasticities31
obtained when a ten-year period of adjustment (of quantity to price) was
allowed for.
Table 4 presents estimates of substitution elasticities for several coun-
tries based on price and quantity changes between (a) 1970 and 1972
and (b) 1970 and 1973. For the United States (for period (a) only),
estimates are also provided for some first-digit SITC groups.
What is generally striking about the estimates is their relatively small
size. With the exception of the United States, practically all countries have
a substitution elasticity of one or less, even when the period allowed for
is three years (1970-73).

V. Direction of Causality

Throughout this study, it has been assumed that exchange rate changes
affect the prices of traded goods, and not the converse; this is a fairly

31 See Kreinin, "A Further Note" (cited in footnote 11).

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 EFFECT OF EXCHANGE RATE CHANGES ON TRADE 323

TABLE 4. ELEVEN INDUSTRIAL COUNTRIES: ESTIMATED SUBSTITUTION

ELASTICITIES, 1970-72 AND 1970-73 1

Country Commodity Group2 1970-72 1970-73

Canada All commodities -1.0 -0.5

Denmark -1.1 -1.4
..

Finland -0.8
France -1.0 -0.4

Germany, Fed. Rep. -0.5 -0.5

Italy -1.2 -1.3

Japan -0.8 -0.2

Netherlands -0.4

Norway -0.8
Sweden " -0.6
United States " -1.8 -0.8
SITC 5 -1.2
SITC 6 -0.5 ...
SITC 7 -1.5 ...
SITC 8 -1.8

1 Empty cells indicate results that a

wrong sign. The estimates for Belg
2 SITC denotes Standard International Trade Classification.

safe assumption for the period under review. While only a properly speci-
fied distributed lag model can provide a conclusive test of this proposition,
it was suggested long ago by Gustav Cassel that the causation runs from
exchange rates to prices in a period of fixed exchange rates, and from
prices to exchange rates in a period of freely fluctuating rates.32 The
evidence presented in this study, based on the Smithsonian Agreement,
was obtained in the context of discrete exchange adjustments in a regime
of fixed rates. Moreover, the price comparisons between the 1970 average
and the 1972 average, with most exchange variations occurring in August-
December 1971, introduce two sequential time lags, of roughly 13 and 11
months, respectively, between the exchange rate changes and the two price
bases being compared. These features strongly suggest (although they do
not guarantee) that the causal effect is from exchange rate changes to
price changes.
This conjecture is supported by the results pertaining to the United
States, a country which was at one extreme on the spectrum of exchange
variations (i.e., it experienced the largest effective devaluation). It is well
known that the U. S. competitive position on world markets deteriorated
greatly in the 1960s, especially in the second half of the decade, and it

32 See Harry G. Johnson and Jacob A. Frenkel, "Essential Concepts and His-
torical Origins," in The Monetary Approach (cited in footnote 7), p. 29.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
324 INTERNATIONAL MONETARY FUND STAFF PAPERS

was this deterioration that led to the dollar devaluations in the early
If causation ran from prices to exchange rate adjustments, then
prices denominated in dollars (a proxy for domestic prices) wou
been expected to move up (in a relative sense), leading to the dev
of the dollar. Instead, no export price movement accompanied the
exchange adjustment-that is, a 100 per cent pass-through effect was
observed on the export side. This is consistent with an exchange adjust-
ment to price change causality, when the export supply elasticities are
infinite or nearly so. A similar point can be made concerning the terms
of trade. The terms of trade of the United States deteriorated, and those
of the Federal Republic of Germany and Japan improved following the
exchange adjustments. Again, this suggests that it was exchange rates
that influenced price movements.
By March of 1973, the fixed exchange rate regime gave way to fluctu-
ating rates. The purchasing-power-parity theory of exchange rate determ-
ination postulates that variations in (some index of) domestic prices
determine exchange rate fluctuations. Since exchange rate changes also
affect the prices of traded goods, the direction of causality can run both
ways. Consequently, in a 1970-73 comparison of exchange rate variations
with price changes, the causal relation is probably mixed. Indeed, in
studies correlatinig price and exchange rate movements in the recent period
of floating exchange rates, no causal relation can be postulated. Certainly,
a strong departure from, or a complete reversal of, the results mentioned
in the previous paragraph would suggest a causal relation from prices to
exchange rates, at least in part. And a mixed causality is what the results
for 1970-73 strongly suggest.
Using the same technique, this paper investigates the pass-through
effect occurring between (average) 1970 and (average) 1973 in some of
the major industrial countries. It will be recalled that the fixed exchange
rate system broke down, and floating rates were introduced, in March
1973. But, in most cases, the float was managed-sometimes heavily-
by government intervention. For Japan, it is widely assumed that govern-
ment intervention was so intense as to practically preserve the fixed
exchange rate regime. Indeed, the Japanese pass-through results for
1970-73 confirm this, for they were similar to those for 1970-72: 60 per
cent on the import side and 75 per cent on the export side. With a 22
per cent effective revaluation of the yen, this implies a terms-of-trade
improvement of 8 per cent.33 While there was no discernible effect on

33 Yen import prices declined by (0.60 x 22 per cent =) approximately 13 per

cent and export prices declined by (0.25 x 22 per cent =) approximately 5 per
cent.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 EFFECT OF EXCHANGE RATE CHANGES ON TRADE 325

Japan's import volume, its exports are estimated (by the control country
method) to have declined by 23 per cent as a result of the revaluation,
yielding a demand elasticity for Japan's exports of -1.4.
In contrast, the 1970-73 results for the United States reflect a "prices
to exchange rate," or a mixed, causality. The effective dollar exchange
rate fell 15 per cent, with an estimated pass-through of 40 per cent on both
the import and the export sides. This implies a 3 per cent improvement34
in the U. S. terms of trade. The association of depreciation with improved
terms of trade (precisely the reverse of the 1970-72 condition) suggests
a "prices to exchange rate" causality. Mixed causality is suggested by the
results pertaining to other industrial countries.

APPENDIX

Degree of Trade Overlap Among Exporting

and Importing Countries

In developing and testing theories of the commodity compositi

trade, it is often useful to be able to observe which two countries su
similar products to a third market, and which two countries import si
products from a third source. This problem is unrelated to the s
matter of this paper. But since this study required the matching up
commodity bundles exported and imported by pairs of countries, it g
erated (at an intermediate stage) data that shed light on the degr
trade overlap that may prove useful to other researchers.
Tables 5 and 6 present such matrices for French exports and im
respectively. Similar tables were prepared for each of the other indu
countries.35 They are all based on average figures for 1970 and 19
for 1970 and 1973.
There appears to be a fairly high degree of trade overlap among the
industrial countries, especially among the European nations, but the
pattern is much more pronounced among the six original members of the
European Economic Community (EEC). The tables reveal an extreme
form of intra-industry *(as against inter-industry) specialization among
them. This is a phenomenon that has been commented upon in previous

34A (0.40 x 15 per cent =) 6 per cent rise in dollar import prices and a
(0.60 x 60 per cent =) 9 per cent rise in dollar export prices.
35 These are available upon request from the author, whose address is Depart-
ment of Economics, Michigan State University, East Lansing, Michigan 48823.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 TABLE 5. FRANCE: EXPORTS TO 15 INDUSTRIAL COUNTRIES, 1970-

.0
0

Cd

S S z
-
Canada 84% 76 82 80 83 64 71 65 6

United States 97% 86 89 93 92 72 81 71 7

451
Japan 84 68 80 68 69 58 64 58 5
309 364
Austria 90 84 79 90 92 74 88 64 7
337 471 322
Denmark 94 87 84 90 95 78 83 66 8
378 464 322 437
Finland 88 82 75 86 91 66 74 56 6
309 363 249 348 369
Belgium-Luxembourg 1 98 98 90 96 99 98 99 99 9
475 670 395 547 545 413
Germany, Fed. Rep. 98 98 90 96 99 98 99 99 99
478 671 397 548 545 415 1,029
Italy 98 97 90 98 98 98 97 97 98
469 658 393 538 538 411 954 956
Netherlands 98 96 88 95 98 98 96 98 97
464 637 383 532 536 407 903 897 845
Norway 90 83 74 84 92 94 71 80 62 7
320 377 259 366 388 327 440 440 434 435
Sweden 96 89 82 91 96 96 74 83 64 8
404 505 331 460 479 386 592 595 584 58
Switzerland 98 96 90 98 99 98 96 98 98 9
472 650 388 542 537 407 941 944 887 84
United Kingdom 97 92 88 94 91 94 92 94 90 9
457 612 378 513 520 393 803 810 776 75

HOW TO READ THE TABLE:

Observe the upper left-hand comer. There are 451 five-digit Standard In
the United States and Canada (items common to both destinations). They comprise 97 per cent of
per cent of total French exports to the United States.
1 Consolidated figures were used for Belgium and Luxembourg since these were the only figure

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 TABLE 6. FRANCE: IMPORTS FROM 15 INDUSTRIAL COUNTRIES, 1970-7

o
.0

*a a a ?* a S

United States 84% 95 92 92 95 89 94 93 8

Canada 65% 42 53 67 85 42 57 48 4
24 1
Japan 56 19 63 77 26 61 75 75 5
39 6 156
Austria 48 23 57 65 56 56 65 67 5
29 4 131 221
Denmark 51 36 61 65 31 41 60 52 5
277 132 213 164
Finland 23 50 21 24 43 28 29 24 3
116 72 78 78 72
Belgium-Luxembourg l 93 94 92 90 95 91 98 98 9
707 244 405 306 293 117
Germany, Fed. Rep. 95 92 99 97 96 96 99 99 99
783 249 445 329 300 125 917
Italy 83 47 95 94 90 64 93 95 92
695 226 432 314 289 108 796 872
Netherlands 90 77 85 94 93 88 97 96 95
675 229 388 292 210 114 769 815 719
Sweden 62 54 68 71 86 90 68 77 65 63
370 169 253 230 221 108 396 411 382 310
Switzerland 81 61 86 89 89 85 81 87 86 7
568 207 364 278 269 105 626 690 629 58
United Kingdom 88 82 92 92 92 61 91 94 90 8
682 237 402 300 284 112 731 803 720 67
Norway 40 55 37 58 64 90 37 47 36 3
167 101 116 100 106 78 177 182 162 16

HOW TO READ THE TABLE:

Observe the upper left-hand corner. There are 241 five-digit Standard In
which France imports from both Canada and the United States (items supp
French imports from the United States and 84 per cent of total French im
' Consolidated figures were used for Belgium and Luxembourg since thes

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
328 INTERNATIONAL MONETARY FUND STAFF PAPERS

studies of the pattern of EEC trade. In the tables prepared for Fr

the Federal Republic of Germany, Italy, Belgium-Luxembourg, and
Netherlands (on both the export and the import sides), the six EEC me
ber countries are shown to export to, and import from, each other alm
the entire range of potentially traded goods. The extreme level of
overlap among EEC members in the case of French exports and im
is underscored in the middle of Tables 5 and 6, where boxes enclos
data for five of France's EEC trading partners.
It should be noted that a very high trade overlap requires that, in b
supplier (or destination) countries in the pair, the common bund
products supplied to the market in question forms a large propo
(usually over 95 per cent) of the country's total exports to (imports fr
that market. This condition is important because a high proportio
only one of the two countries may merely reflect the large size
economic diversification of the other country in the pair. That condit
invariably met among the original EEC members. For further emp
Table 7 extracts the trade overlap figures of four of Belgium's EEC pa
ners from the Belgian matrices. With the possible exception of Italy,
high overlap is observed throughout. The same pattern holds for the t
of the Federal Republic of Germany, Italy, and the Netherlands. No ot
group of countries (such as the European Free Trade Association o
Scandinavian countries) exhibits such a consistent lack of inter-ind
specialization. Unfortunately, comparable figures are not available
say, the early 1960s that would enable one to observe the developm
that have taken place over time.
All countries examined show a far greater trade overlap in their exp
than in their imports. In other words, countries appear to be much m

TABLE 7. BELGIUM: DEGREE OF OVERLAP IN TRADE WITH FOUR MEMBERS

OF EUROPEAN ECONOMIC COMMUNITY, 1970-72

(In per cent)

Exports Imports

Germany, Nether- Germany, Nether-

France Fed. Rep. Italy lands France Fed. Rep. Italy lands
France - 99 98 99 - 100 99 97
Germany 99 - 99 99 100 - 99 99
Italy 94 94 - 92 76 88 - 79
Netherlands 99 99 99 - 97 99 99
HOW TO READ THE TABLE:
Observe the upper left-hand comer on the export (left) side of the table. 99 p
of Belgium exports to France are products that Belgium also exports to Ge
Likewise, a full 100 per cent of Belgian imports from France are products that
also imports from Germany.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
 EFFECT OF EXCHANGE RATE CHANGES ON TRADE 329

specialized in the sources of their imports than in the destinations of thei

exports. This is true for all countries examined here, including the small
European nations. On the export side, the Federal Republic of Germany
appears to have the highest trade overlap; it exports practically all poten-
tially traded goods to all the European countries. It "blankets the world"
with its exports much more than any other country, including the United
States.

This content downloaded from 203.129.195.130 on Tue, 03 Mar 2020 03:32:14 UTC
All use subject to https://about.jstor.org/terms
Marketing
 Marketing
Definition:
The business of promoting and selling
products or services, including market research
and advertising is called as marketing.
Primary and essential skill of economist
Attitude based
 Marketing steps

• Step 1: Know the Business.

• Step 2: Determine Target.
• Step 3: Analyse Competitors.
• Step 4: Set Goals.
• Step 5: Strategies.
• Step 6: Get to Work
 Pillars of marketing
Product……….2
Price……………3
Place…………..4
Promotion.....1
Example:
1.Akshay kumar Promotion
2. Domex Product
3. Rs.140 Price
4. Using all cities Place
 Product Life Cycle
• The term product life cycle refers to the length of
time a product is introduced to consumers into
the market until it's removed from the shelves.
• Cant considered for re-usable

Stages of Product life cycle

1. R&D
2. Introduction
3. Growth
4. Maturity
5. Decline
 Maruti 800
• Maruti 800 is a small city car that was
manufactured by Maruti Suzuki in India from
1983 to 2014.
• Maruti 800 –Product life cycle will be live up
to spares supply from the company.
 What about Book?
• No R&D (ebook is a innovation-Kindley)
• No Maturity
• No Decline-Das kapital, The origin of species
books till available in Market
• No spare parts & functioning model
 Marketing Research
Aim:
• Right product at Right place with profit sales
• Hills station and Winter season---- No need to
market Ice creams.
• Data's and market trend are obtained thru
market research.
 Marketing Research/Survey
 Get a “feel” for the relationship between the product and it’s
market, the project analyst may informally talk to customers,
competitors, middlemen and other in the industry.
 Look at the experience of the company to learn about the
purchasing power of customer, action & strategies of
competitors.
 The objectives of market & Demand analysis, to
answer the following question : (for air coolers)
 Who are the buyers of air cooler?
 What is the total current demand for air coolers?
 What price will the customer be willing to pay for the
improved air cooler.
 What price & warranty will ensure its acceptance?
 What are the prospects of immediate sales? etc.
 Conduct of Market Survey
 The market survey may be a census survey or a sample
survey.
 Census survey are employed principally for intermediate
goods & investment goods when such goods are used by
a small number of firms.
• Total demand
• Growth of demand
• Income
• Buying motive
• Purchase plans
• Unsatisfied needs and attitude of people towards
products and services
• Characteristics of buyer
 Sources of Information
• Census survey
• National sample survey reports
• 5 years plans
• India year book
• Economic survey reports
• Annual survey of industries
• Annual bulletin of export and import
• Stock exchange directory
• Monthly bulletins of RBI
• Publications of advertising agencies
• Industry potential surveys
 Characterization of the Market
 Effective Demand in the Past and Present
• Production + Imports – Exports – Change in stock level
 Breakdown of Demand
– Nature of Product
– Consumer Groups
– Geographical Division
 Price
 Methods of Distribution and Sales Promotion
 Types of Consumers
 Listing of Supply and Competition
 Government Policy
Branding
• Definition:
A brand is a name, term, design, symbol or any
other feature that identifies one seller's good or service
as distinct from those of other sellers.
Branding often takes the form of a recognizable symbol
to which consumers easily identify, such as a logo.
Common.
• First and foremost, a unique brand can
have a huge impact on giving a
competitive advantage over rivals and
helping you acquire and retain
customers at a much lower cost.
 Importance of
Branding

• Understand Customers
• Define brand person
• Crystalize the brand promise
• Perfect visual assets
• Refine customer experience
• Remember to give back
• The process involved in creating a unique name
and image for a product in the consumers' mind,
mainly through advertising campaigns with a
consistent theme.
• Branding aims to establish a significant and
differentiated presence in the market that attracts
and retains loyal customers. Branding is almost
intangible.
• The purpose of branding is knowing and consistently
living from a true identity, from a real story, so that
executive leadership, sales, marketing, product, support,
operations, and corporate culture all align and mature in
a compelling manner of the product.
• Good branding elevates a business and builds
recognition and loyalty. Customers are attracted to
brands that share similar values with them. When you
showcase what you value through branding, customers
will develop an emotional connection to you.
 Types of Brands
• Individual Brands.
• Service Brands.
• Organization Brands.
• Personal Brands.
• Group Brands.
• Event Brands.
• Geographic Place Brands.
• Private-Label Brands.
Examples
Personality
• Five major traits
underlie personality,
according to psychologists.
They are
introversion/extroversion,
openness, conscientiousness,
extraversion, agreeableness
and neuroticism.
• The combination of characteristics or qualities that form
an individual's distinctive character.
• Personality, a characteristic way of thinking, feeling, and
behaving. Personality embraces moods, attitudes, and
opinions and is most clearly expressed in interactions
with other people. It includes behavioural characteristics,
both inherent and acquired, that distinguish one person
from another and that can be observed in people’s
relations to the environment and to the social group.
 Motivation
• Motivation is the word derived from the word
'motive' which means needs, desires, wants or drives
within the individuals. It is the process of stimulating
people to actions to accomplish the goals. In the
work goal context the psychological factors
stimulating the people's behaviour can be - desire for
money. success.
• Extrinsic Motivation----Extrinsic motivation
comes from outside us.
• Intrinsic Motivation----Intrinsic motivation is
done for internal reasons, for example to align
with values or simply for the hedonistic
pleasure of doing something.
• Introjected Motivation.
• Identified Motivation.
 Fishers man son---- President of India
 Tourist Guide------- Alibaba owner
 School teacher son---- King of Software
 Petrol station worker----Reliance
 Hotel supplier boy----IAS officer (Veerapandian, Madurai)
 House wife---IPS officer, Mumbai (M.Ambika)
 School teacher--- SRM university
 A drop out degree holder--- CavinKare
 Leadership

• The action of leading a group of people or an

organization.
• A great leader posses a clear vision, is courageous, has
integrity, honesty, humility and clear focus.
• Great leaders help people reach their goals, are not
afraid to hire people that might be better than them and
take pride in the accomplishments of those they help
along the way.
 Leadership Skills
• Leadership is the art of motivating a group of
people to act toward achieving a common goal.
They are the person in the group that possesses
the combination of personality
and leadership skills to make others want to
follow their direction.
• Communication.
• Awareness.
• Honesty/Integrity.
• Relationship Building.
• Innovation.
• Developing Leadership Skills.
 Conti…..

• Set the right example, being a leader.

• Continuous development of your leadership skills.
• Be technically proficient.
• Make sound and timely decisions.
• Seek and take responsibility for your actions.
• Positive Attitude.
• Keep your team informed.
• Get to know your team.
• Sundar Pichai
• Indra Nooyi-Pepsi
• Sathya Nadella-Microsoft
• Shantanu Narayanan-Adobe
• Natarajan Chandrasekaran-TATA
• Ajay Banga-Master Card
Working in Teams
• Working with a group of people to achieve a shared
goal or outcome in an effective way.
• Listening to other members of the team.
• Taking everyone's ideas on board, not just your own.
• Working for the good of the group as a whole.
• Having a say and sharing responsibility.
 Team Skills
• Communication.
• Conflict resolution.
• Rapport-building and listening.
• Decision-making.
• Problem-solving.
• Organizational and planning skills.
• Persuasion and influencing skills.
• Reliability.
 Advantages of Team Work
• Fosters Creativity and Learning.
• Creativity thrives when people work together on
a team.
• Blends Complementary Strengths.
• Builds Trust.
• Teaches Conflict Resolution Skills.
• Promotes a Wider Sense of Ownership.
• Encourages Healthy Risk-Taking.
• Shared understanding of the team's mission
• Commitment to the team's goals
• Clearly defined roles and responsibilities
• Agreed-upon ground rules
• An established decision-making model
Appendix
 Real Economics?
1 gm gold= Rs.3834
8 gm gold= Rs.30,672+Wastage (1 gm)+Making Charge+ Tax
8 gm Gold totally= 36,206
1 gm copper= Rs.3.63
8 gm= 1.5gm Copper+6.5gm Gold
= 5.445+24,921
Actual Gold rate= 24,926.445
Difference= 36,206-24,926.445
Extra paid= Rs.11,279.555/8 gm Gold
Real face of Economic Ghost