ECONOMICS ASSIGNMENT 3rd SEM
ECONOMICS ASSIGNMENT 3rd SEM
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INDEX
1. DECLARATION 3
2. ACKNOWLEDGEMENT 4
3. INTRODUCTION 5
4. HOW TO CALCULATE TERMS OF TRADE 8
5. FACTORS AFFECTING TERMS OF TRADE 9
6. EFFECTS ON NATIONS WELFARE 20
7. CASE STUDY 28
8. BIBLIOGRAPHY 39
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DECLARATION
I, hereby declare that the assignment entitled “Terms of Trade and Nations Welfare” is an
outcome of my own efforts under the guidance of Dr.Digvijay Katoch. I further declare that the
following project has not been submitted to any other university. I followed the guidelines
provided by the university.
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ACKNOWLEDGEMENT
I would love to put conversational expression of gratitude to Dr. Digvijay Katoch, Assistant
Professor at Himachal Pradesh National Law University providing me an opportunity through
this project to explore the various sections under the topic ”Terms of Trade and Nations
Welfare”helping me assimilate and pickup on it. I believe this will help me comprehend better
and get an enhanced hang on some aspects of the Terms of Trade. I would like to thank all the
people who helped me finding the resources for making the project. At last I would like to
thank all those who helped me compile the research in this project work.
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INTRODUCTION
TERMS OF TRADE:
The terms of trade of a nation are defined as the ratio of the price of its exports to the price of its
imports. Since in a two-nation world, the exports of a nation are the imports of its trade partner,
the terms of trade of the latter are equal to the inverse, or reciprocal, of the terms of trade of the
former.
In a world of many (rather than just two) traded commodities, the terms of trade of a nation are
given by the ratio of the price index of its exports to the price index of its imports. This ratio is
usually multiplied by 100 in order to express the terms of trade in percentages. These terms of
trade are often referred to as the commodity or net barter terms of trade to distinguish them from
various other measures of the terms of trade.
An improvement in a nation’s terms of trade is usually regarded as good for the nation in the
sense that the prices that the nation receives for its exports rise relative to the prices that it pays
for imports.
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Even if country l’s terms of trade improve over time, we cannot conclude that country 1 is
necessarily better of because of this, or that country 2 is necessarily worse off because of the
deterioration in its terms of trade.
Changes in a country’s terms of trade are the result of many forces at work both in that nation
and in the rest of the world, and we cannot determine their new effect on a nation’s welfare by
simply looking at the change in the country’s terms of trade.
This means that between 1980 and 1998 the nation’s export prices feel by 14% in relation to its
import prices.
This means that from 1980 to 1998 the country’s capacity to import (based on its export
earnings) increased by 3.63% (even though Px/Pm declined). The change in the income terms of
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trade is very important for developing nations, since they rely to a large extent on imported
capital goods for their development.
A nation’s single factoral terms of trade (S) are given by:
S = (Px/Pm) Zx … (3)
where Zx is a productivity index in the country’s export sector. Thus, S measures the amount of
imports the nation gets per unit of domestic factors of production included in its exports.
For example, if productivity in the country’s export sector rose from 100 in 1980 to 130 in
1998 then the country’s single factoral terms of trade increased to:
S = (95/110)130 = (0.8636) (130) = 112.27
This means that in 1998 the nation received 12.27% more imports per unit of domestic factors
embodied in its exports than it did in 1980. Even though the nation shares part of its productivity
increase in its export sector with other nations, the nation was better off in 1998 than it was in
1980 (by more than indicated by the increase in/and even though N declined).
The concept of the single factoral terms of trade can be extended to measure the country’s double
factoral terms of trade (D), given by
Of the four terms of trade defined, N, I and S are the most important. D does not have much
significance for developing countries and is not usually measured. The most significant terms of
trade for developing countries are I and S. However, since N is the easiest to measure, it is
widely used. Indeed, N is often referred to simply as “the terms of trade”.
I and S can rise even when N declines. This is generally regarded as favourable to a developing
country. Of course, the most favourable situation is when N, I and S all increase. On the other
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hand, the worst possible situation from the point of view of a developing country occurs when all
three terms of trade deteriorate at the same time.
The rate at which one country’s products exchange for those of another is known as the term of
trade. If the terms of trade move in a nation’s favour, it gets a larger quantity of imports for a
given quantity of its exports. This happens because import prices fall relative to export prices.
For example, if in a certain year India can import 10 tonnes of steel in exchange for the export of
one Maruti car, and in the following year 15 tonnes of steel in exchange for the same car its
terms of trade will improve. If, on the other hand, 2 cars had to be exported in exchange for 10
tonnes of steel in the second year, then the terms of trade would have moved against India.
Let us consider a simple example. If the index rises, then it will indicate a trend favourable to
India. For example, assuming the index of export prices changes to 120 and the index of import
prices to 60.
Then (120/60) × 100 = 200, which means that India’s exports are exchanged for twice as many
imports as in the base year, when the Index was 100. On the other hand, a fall in the terms of
trade index indicates an unfavourable trend. This is because the prices of imports will have risen
faster to that of exports.
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The point at which a country’s terms of trade settle depends on the strength of domestic demand
for the goods it imports relative to foreign demand for the goods it exports. The stronger a
country’s demand for imports, the higher the price it will have to pay for them, and the less
favourable its terms of trade. The stronger the foreign demand for a country’s exports, the higher
the price it will get for them, and the more favourable in terms of trade.
It is obvious that the terms of trade would change with the change in reciprocal demand, which
primarily depends on the world prices of commodities entering into international trade. A change
in such prices, would also bring about a change in the terms of trade.
The terms of trade among the trading countries are affected by several factors.
Some prominent factors out of them are discussed below:
Factor # 1. Reciprocal Demand:
The reciprocal demand signifies the intensity of demand for the product of one country by the
other. If the demand for cloth, exportable commodity of country A, is more intense (or inelastic)
in country B, the latter will offer more units of steel, its exportable product, to import a given
quantity of cloth. On the contrary, if the demand for cloth in country B is less intense (elastic),
then B will offer smaller quantity of steel to import the given quantity of cloth.
If the reciprocal demand for steel in country A increases, the offer curve of country A will shift
to the right as it will be willing to offer more quantity of cloth for the given import of steel. On
the contrary, a decrease in the reciprocal demand for steel in country A, will cause a shift in its
offer curve to the left as it will offer a lesser quantity of cloth to import the same quantity of
steel. In the former case, the terms of trade get worsened and in the latter case they get improved
for country A.
From the point of view of country B, if there is an increase in the reciprocal demand for cloth in
country B, the offer curve of this country will shift to the left and the terms of trade for this
country become favourable. On the opposite, a decrease in the reciprocal demand for cloth in
country B results in a shift in the offer curve of this country to the right. The consequence is the
worsening of the terms of trade for this country.
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In Figs. 12.1 (i) and 12.1 (ii), cloth, the exportable commodity of country A and importable
commodity of country B, is measured along the horizontal scale. Steel, the exportable
commodity of country B and importable commodity of country A, is measured along the vertical
scale.
In Fig. 12.1 (i), given the offer curves OA and OB of countries A and B respectively, exchange
takes place at P where country A imports PQ quantity of steel and exports OQ quantity of cloth.
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If the reciprocal demand for steel in country A increases, the offer curve of A shifts to the right
to OA1. The intersection of OA1 and OB takes place at P1, which is the point of exchange. At this
point, country A imports P1Q1 quantity of steel and exports OQ1 quantity of cloth.
Since Tan α2 > Tan α, there is an improvement in the terms of trade for country A in this
situation.
In Fig. 12.1 (ii) originally OA and OB are the offer curves of countries A and B respectively.
The exchange takes place at P where country A imports PQ quantity of steel and exports OQ
quantity of cloth. If reciprocal demand for cloth in country B increases, the offer curve of
country B shifts to the left to OB1.
The exchange, in this case, takes place at P1 and country A imports P1Q1 quantity of steel and
exports OQ1 quantity of cloth. If the reciprocal demand for cloth in country B decreases, the
offer curve of country B shifts to the right to OB2. In this case exchange takes place at P2 where
country A imports P2Q2 quantity of steel and exports OQ2 quantity of cloth.
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Since Tan a1 > Tan α, there is an improvement in the terms of trade for country A at P1 and
worsening of the terms of trade for country B. Since Tan α2 < Tan α, there is worsening of the
terms of trade for country A at P2 and improvement in the terms of trade for country B.
Factor # 2. Tariff:
When a country imposes tariffs on imports from the foreign country, it implies a lesser
willingness to absorb the foreign products. It means the reciprocal demand in the tariff- imposing
country for the foreign product has got reduced. The tariffs or import duties are, therefore, likely
to improve the terms of trade for the tariff- imposing country. It may be explained through Fig.
12.2.
In Fig. 12.2, OA is the offer curve of country A and OB is the offer curve of country B. Their
intersection determines the point of exchange P where country A imports PQ quantity of steel
and exports OQ quantity of cloth. The TOT for country A at P = (QM/QX) = (PQ/OQ) = Slope of
Line OP = Tan α.
When tariff is imposed by country A on steel, the offer curve of country A shifts to the left to
OA1. The exchange now takes place at P1 where P1Q1 quantity of steel is imported in exchange
of OQ1 quantity of cloth. The TOT for A at P1 = (QM/QX) = (P1Q1/OQ1) = Slope of Line OP1 =
Tan α 1. Since Tan α1 > Tan α, the terms of trade have become favorable for the tariff-imposing
country A.
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In this connection, it should be remembered that tariff will improve the terms of trade for the
tariff-imposing country, if the elasticity of offer curve of the other country is more than unity but
less than infinity. If the foreign country B imposes retaliatory tariff of the equivalent or relatively
larger magnitude, the effect of imposition of tariff by the first country A may get off-set or more
than off-set.
Factor # 3. Changes in Tastes:
The terms of trade of a country may also be affected by the changes in tastes. If tastes or
preferences of the people in country A shift from the product Y of country B to its own product
X, the terms of trade will become favourable to country A. In an opposite situation, the terms of
trade will turn against this country. It may be shown through Fig. 12.3.
In Fig. 12.3, the offer curves OA and OB of countries A and B respectively intersect each other
at P. At this point of exchange, country A imports PQ quantity of Y and exports OQ quantity of
X.
The TOT for country A at P = (QM/QX) = (PQ/OQ) = Slope of Line OP = Tan α. If people in
country A do not have a stronger preference for the commodity Y and their preference or taste
shifts towards their own product X, the offer curve of country A shifts to the left to OA1. Now
exchange takes place at P1. Country A buys P1Q1 quantity of Y in exchange of OQ1 quantity of
X. The TOT for country A at P1 = (QM/QX) = (P1Q1/OQ1) = slope of Line OP1 = Tan α1. Since
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Tan α1 > Tan α, there is an improvement in the terms of trade for country A. On the opposite, the
shift in preference towards the foreign product Y will result in the worsening of terms of trade
for the home country A.
Factor # 4. Changes in Factor Endowments:
If there is an increase in the supply of labour in country A, specialising in the production of
labour-intensive commodity cloth, while factor endowments in country B remain unchanged, the
fall in labour cost will lower the price of cloth. Consequently, more quantity of cloth will be
offered by country A for the same quantity of steel resulting in the terms of trade becoming
unfavourable to A. If labour becomes scarcer in this country, the terms of trade are likely to
become favourable for it. This may be shown through Fig. 12.4.
In Fig. 12.4, given OA and OB as the offer curves of countries A and B respectively, exchange
takes place originally at P. Country A exports OQ quantity of cloth and imports PQ quantity of
steel.
The TOT for country A at P = (QM/QX) = (PQ/OQ) = Slope of Line OP = Tan α. If there is an
increase in the supply of labour in this country, the price of labour will fall. There will also be a
fall in the price of labour-intensive commodity cloth relative to the price of steel. For the same
quantity of cloth, now less quantity of steel can be bought.
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Therefore, the offers curve of country A shifts to the right to OA1. The exchange takes place at
P1 where P1Q1 quantity of steel is imported in exchange of OQ1 quantity of cloth. The TOT for
country A at P1 = 9QM/QX) = (P1Q1/OQ1) = Slope of Line OP1 = Tan α1. Since Tan α1 < Tan α,
terms of trade become unfavourable for country A subsequent to change in the factor
endowments, i.e., increased supply of labour.
Factor # 5. Changes in Technology:
The terms of trade of a country get affected also by the changes in techniques of production. As
there is technological improvement in the home country, say A, there is rise in productivity
and/or a fall in the cost of producing exportable commodity, say cloth. If the technological
progress is labour-saving in this labour-intensive export sector (cloth industry) there will be
worsening of the terms of trade as the offer curve of country A will shift to the right. This may
be explained through Fig. 12.5.
In Fig. 12.5, OA and OB are the-offer curves of countries A and B respectively. The exchange
takes place at P where PQ quantity of steel is imported in exchange of OQ quantity of cloth.
The TOT for A at P = (QM/QX) = (PQ/OQ) = Slope of Line OP = Tan α. If labour-saving
technical progress takes place in the labour-intensive export sector (cloth industry), the offer
curve of country A shifts to the right to OA1 where P1O1 quantity of steel is imported in
exchange of OQ1 quantity of cloth. The TOT for country A at P1 = (QM/QX) = (P1Q1/OQ1) =
Slope of Line OP1 = Tan α1. Since Tan α1 < Tan α, there is worsening of the terms of trade for
this country after technological progress.
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In case this type of technical progress takes place in the import-competing sector in this county,
there will be an improvement in the terms of trade. If capital-saving technical progress takes
place in labour-intensive export sector, there can still be the possibility of improvement in the
terms of trade.
Factor # 6. Economic Growth:
The economic growth involves a rise in real national product or income of a country over a long
period. As growth takes place, there is an expansion in the productive capacity of the country.
The increased productive capacity may result from the increased supply of productive factors. It
is supposed that there are two countries A and B.
The former is the labour-abundant home country and cloth is its exportable product, which is
labour-intensive. Steel, the capital-intensive commodity, is its importable product from the
foreign country B. The offer curves of two countries are given.
As the supply of labour in the labour- abundant country A increases or growth takes place, the
offer curve of this country will shift to the right. The cost and price of exportable commodity
falls relative to the cost and price of steel in country B. As a result, this country will offer more
quantity of cloth for the same quantity of steel. In this situation, the terms of trade will get
worsened for the growing home country A, although the volume of trade will get enlarged.
If the supply of scarce factor capital increases, subsequent to growth, the cost and price of
importable good steel will fall relative to the price of cloth. More quantity of steel can be
obtained for the same quantity of cloth. In this case, the offer curve of country A will shift to the
left. This will cause the improvement in the terms of trade for the growing home country A but
the volume of trade will get reduced. This may be explained through Fig. 12.6.
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In Fig. 12.6, originally OA and OB are the offer curves of two counties. The exchange takes
place at P. Country A exports OQ quantity of cloth and imports PQ quantity of steel. The TOT at
P = (QM/QX) = (PQ/OQ) = Slope of Line OP = Tan α. If growth takes place and supply of
abundant factor labour increases, the offer curve of A shifts to the right to OA1 and exchange
takes place at P1. P1Q1 quantity of steel is imported and OQ1 quantity of cloth is exported. The
TOT for A at P1 = (QM/QX) = (P1Q1/OQ1) = Slope of Line OP1 = Tan α1.
ADVERTISEMENTS:
Since Tan α1 < Tan α, there is worsening of the terms of trade for the home country after growth.
Since there is an expansion of both exports and imports, the volume of trade has however,
increased. If growth involves the increased supply of scarce factor capital, the offer curve of
country A will shift to the left to OA2. In this case, exchange takes place at P2. The quantity
imported of steel is P2Q2 whereas the quantity exported of cloth is OQ2.
The TOT at P2 = (QM/QX) = (P2Q2/OQ2) = Slope of Line OP2 = Tan α2.
Since Tan α2 > Tan α, the terms of trade for the growing home country have improved. But in
this case, the volume of trade of the country has decreased. The export and import of cloth and
steel respectively have been less than quantities transacted before the process of growth.
In the above two cases, it was assumed that the relative prices of the two commodities undergo
change. Suppose the prices of cloth and steel remain unchanged even after growth, the terms of
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trade will remain unchanged. If growth involves increased supply of abundant factor labour and
prices of two commodities remain the same, the exchange may occur at P4 where the slope of
line OP is exactly equal to the slope of line OP4 (P and P4 lie on the same line).
The terms of trade remain the same there, although the volume of trade is much larger than at P.
If there is increased supply of scarce factor capital but the prices of commodities remain the
same, the exchange occurs at P3. The terms of trade at P3 are exactly equal to the term of trade at
P (both the points lie on the same line OP). So there is no change in the terms but the volume of
trade is smaller than volume of trade at the original position P. It is now clear that growth
process can lead to deterioration or worsening of the terms of trade or these may remain
unchanged.
Factor # 7. Devaluation:
Devaluation is the reduction of the value of home currency in relation to the value of foreign
currency. Since devaluation causes a lowering of export prices relative to import prices, the
terms of trade are supposed to get worsened after devaluation of the home currency.
In fact there is much controversy about the impact of devaluation upon the terms of trade among
the economists. F.D. Graham and several other classical theorists held the view that the
devaluation would leave the terms of trade unaffected because the countries transact at the
international prices upon which they have little control.
The neo-classical, theorists, including Joan Robinson, on the contrary, maintained that most
countries specialised in the export of a few commodities, the foreign demand of which was
relatively inelastic while, at the same time, they imported such goods, the supply of which was
relatively more elastic. Consequently devaluation tends to deteriorate their terms of trade.
This is particularly true in the case of the developing countries. If, however, the country enjoys a
monopsony power, it will specialise in imports while exporting a variety of goods. It is likely to
make imports at a lower price even after devaluation and the terms of trade, as a consequence,
will get improved.
The devaluation can be successful or effective if the export prices fall and import prices rise. It
means the successful devaluation is likely to make the commodity terms of trade unfavourable.
Even the gross barter terms of trade are likely to turn adverse in the event of successful
devaluation that result in a balance of trade surplus. As a matter of fact, whether the terms of
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trade will become adverse or favourable, is determined by the elasticities of demand and supply
of exports and imports of the devaluing country.
If the elasticities of supply of exports and imports are higher than the elasticities of demand for
exports and imports, so that the product of demand elasticity co-efficients is less than the product
of supply elasticity co-efficients (DX.DM < SX.SM), there will be deterioration in the terms of
trade after devaluation. Here DX and DM are elasticity coefficients of the demand for exports and
imports respectively. SX and SM are the elasticity coefficients of supply of exports and imports
respectively.
If the product of elasticity co-efficients related to demand for exports and imports is exactly
equal to the product of the elasticity co-efficients of supply of exports and imports respectively
(DX.DM = SX.SM), the devaluation will leave the terms of trade unchanged. If the product of
elasticity co-efficients of demand for exports and imports is greater than the product of elasticity
co-efficients of supply of exports and imports, (DX.DM > SX.SM), there will be an improvement
in the terms of trade after devaluation.
To sum up, the terms of trade will worsen, remain unchanged and improve, consequent
upon devaluation, if:
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In order to get hold of required foreign currencies for making repayments, there may be sale of
home-produced goods at rather low prices. The fall in export prices relative to import prices will
again result in the deterioration in the net barter terms of trade.
Factor # 10. Import Substitutes:
If there is sufficient production of close substitutes for import goods within the home country, its
reciprocal demand for the foreign products will be weak and the terms of trade are likely to
become favourable for the home country. On the opposite, if the close substitutes of the import
goods are not available in the home country, the reciprocal demand for foreign products may be
relatively high. As a result, the terms of trade are likely to be unfavourable for the home country.
There can be several other minor influences upon the terms of trade such as price movements,
business cycles, transfer problems and political conditions.
EFFECTS ON NATIONS WELFARE
The base case is used to demonstrate how GDP compares with domestic spending in the simplest
scenario. Here we assume that the country does not run a trade deficit or surplus in either of the
two periods and that no GDP growth occurs between periods. No trade imbalance implies no net
international borrowing or lending occurs on the financial account. The case mimics how things
would look if the country were in autarky and did not trade with the rest of the world.
Note from the adjoining figure that domestic spending, shown as the aqua bar graph, is exactly
equal to GDP in both periods. Since domestic spending is used to measure national welfare, we
see that the average standard of living remains unchanged between the two periods. All in all,
nothing very interesting happens in this case, but, it will be useful for comparison purposes..
Case 2:
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(Current Account deficit period 1; No GDP Growth between periods)
In case 2 we assume that the country runs a current account, or trade, deficit in the first period.
We'll also assume that the resultant financial account surplus corresponds to borrowing from the
rest of the world, rather than asset purchases. These borrowed funds are assumed to be repaid in
their entirety in the second period. In other words, we'll assume that loans are taken out in the
first period and that the principal and interest are repaid completely in the second period. We
also assume that there is no GDP growth between periods.
As shown in the adjoining diagram, the trade deficit in the first period implies that domestic
spending, DS1, exceeds GDP1. The difference between DS1 and GDP1 represents the current
account deficit as well as the value of the outstanding principal on the foreign loans. The extra
consumption the country can enjoy is possible because it borrows funds from abroad and uses
them to purchase extra imports. The result is the potential for a higher standard of living in the
country in the period in which it runs a current account deficit if the extra funds are not directed
into domestic investment.
In the second period the borrowed funds must be repaid with interest. The repayment reduces
domestic spending below the level of GDP by the amount of the principal and interest repayment
as shown by the light colored areas in the diagram.(1) Since GDP does not change between the
two periods, DS2 will lie below GDP1. What this means is that the average standard of living
can fall during the period in which the loan repayment is being made.
This outcome highlights perhaps the most important concern about trade deficits. The fear is that
large and persistent trade deficits may require a significant fall in living standards when the loans
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finally come due. If the periods are stretched between two generations, then there is an
intergenerational concern. A country running large trade deficits may raise living standards for
the current generation, only to reduce them for the next generation. It is then as if the parents'
consumption binge is being subsidized by their children.
Case 3:
In case 3 we assume, as in case 2, that the country runs a trade deficit in the first period, that the
trade deficit corresponds to borrowing from the rest of the world and that in period 2 all of the
loans are repaid with interest. What differs here is that we will assume GDP growth occurs
between periods 1 and 2. As we'll see growth can significantly affect the long term effects of
trade deficits.
In the adjoining diagram note that period 1 domestic spending, DS1, lies above GDP in period 1,
GDP1. This arises because a trade deficit implies that the country is borrowing from the rest of
the world which, in turn, allows it to spend (and consume) more than it produces.
In period 2 we assume that GDP has grown to GDP2 as shown in the graph. The principal and
interest from first period loans are repaid which lowers domestic spending to DS2. Note that
since domestic spending is less than GDP2, the country must be running a trade surplus. Also
note that the trade surplus implies that consumption, and the average standard of living, is
reduced below the level obtainable with balanced trade in that period. In a sense, then, the trade
deficit has a similar long-term detrimental effect as in case two.
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However, it is possible that the first period trade deficit, in this case may actually be generating a
long-term benefit. Suppose for a moment that this country's balanced trade outcome over two
periods would look like the base case, case 1. In that case, balanced trade prevails but no GDP
growth occurs, leaving the country with the same standard of living in both periods. Such a
country may be able to achieve an outcome like case 3, if, it borrows money from the rest of the
world in period one, - thus running a current account deficit - and uses those funds to purchase
investment goods, which may in turn stimulate GDP growth. If GDP rises sufficiently, the
country will achieve a level of domestic spending that exceeds the level that would have been
obtained in the base case.
Indeed, it is even possible for a country's standard of living to be increased in the long term
entirely because it runs a trade deficit. In case three, imagine that all of the borrowed funds in
period one are used for investment. This means that even though domestic spending rises, the
average standard of living would remain unchanged, relative to the base case, because
investment goods generate no immediate consumption pleasures. In period two, the higher level
of domestic spending may be used for increased consumption which would cause an increase in
the country's average living standards. Thus, the country is better-off in both the short term and
long term with the unbalanced trade scenario compared to the balanced trade case.
Case 4:
In this case we assume that the country runs a trade surplus in the first period and that no GDP
growth occurs between periods. A surplus implies that exports exceed imports of goods and
services and that the country has a financial account deficit. We will assume that the financial
account deficit corresponds entirely to loans made to the rest of the world. We can also refer to
these loans as saving, since the loans imply that someone in the country is forgoing current
consumption. In the future, these savings will be redeemed along with the interest collected in
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the interim. We shall assume that all of these loans are repaid to the country, with interest, in the
second period.
In the adjoining diagram we see that in the first period, when the trade surplus is run, domestic
spending, DS1, is less than national income or GDP. This occurs because the country is lending,
rather than consuming, some of the money available from production. The excess of exports over
imports represents goods which could have been used for domestic consumption, investment,
and government, but are instead being consumed by foreigners. This means that a current
account surplus reduces a country's potential for consumption and investment below that
achievable with balanced trade. If the trade surplus substitutes for domestic consumption and
government spending, then the trade surplus will reduce the country's average standard of living.
If the trade surplus substitutes for domestic investment, then average living standards would not
be affected, but the potential for future growth can be reduced. In this sense trade surpluses can
be viewed as a sign of weakness for an economy, especially in the short-run during the periods
the surpluses are run. Surpluses can reduce living standards and the potential for future growth.
Nevertheless this does not mean that countries should not run trade surpluses or that trade
surpluses are necessarily detrimental over a longer period of time. As shown in the diagram,
when period two arrives the country redeems its past loans with interest. This will force the
country to run a trade deficit and domestic spending, DS2, will exceed GDP. The trade deficit
implies imports exceed exports and these additional imports can be used to raise domestic
consumption, investment and government spending. If the deficit leads to greater consumption
and government spending, then the country's average standard of living will rise above that
achievable with balanced trade. If the deficit leads to greater investment, then the country's
potential for GDP growth in the third period (not shown) is enhanced.
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In brief, this case describes the situation in which a country forgoes first period consumption and
investment so that in period two it can enjoy even greater consumption and investment.
Consider our individual, Amine, who has an annual income of $30,000 over two periods. This
corresponds to the constant GDP in the above example. Amine would run a trade surplus in
period one if he lends money to others. One way to achieve this is simply to put money into a
savings account in the local bank. Suppose Amine deposits $5000 into a savings account. This
money is then used by the bank to make loans to other individuals and businesses, thus, in
essence Amine is making loans to them with the bank acting as an intermediary. The $5000 also
represent money that Amine does not use to buy goods and services. Thus, in period one Amine
exports $30,000 of labor services, but imports only $25,000 of consumption goods. The excess is
loaned to others so that they might consume instead in the first period. It is clear that Amine's
standard of living, at $25,000, is lower in the first period than the $30,000 he could have
achieved had he not deposited money into savings.
In the second period, we imagine that Amine again earns $30,000 and withdraws all of the
money plus interest from the savings account. Suppose he had earned 10% interest between the
periods. In this case his withdrawal would amount to $5,500. This means that in period two
Amine can consume $35,500 worth of goods and services. This outcome also implies that
Amine's domestic spending capability exceeds his income and so he must be running a trade
deficit. In this case Amine's imports of goods and services at $35,500, exceeds his exports of
$30,000 worth of labor services, thus he has a trade deficit.
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Is this outcome good or bad for Amine? Most would consider this a good outcome. One might
argue that Amine has prudently saved some of his income for a later time when he may have a
greater need. The story may seem even more prudent if Amine suffered a significant drop in
income in the second period to, say, $20,000. In this case the savings would allow Amine to
maintain his consumption at nearly the same level in both periods despite the shock to his
income stream. This corresponds to the words of wisdom that one should save for a rainy day.
Savings can certainly allow an individual to smooth his consumption stream over time.
Alternatively, one might consider the two periods of the story to be middle age and retirement. In
this case it would make sense to save money out of one's income in middle age so that one can
draw upon those savings and their accumulated earnings during retirement when one's income
has fallen to zero.
On the other hand, excessive saving in the first period might make Amine seem miserly. Few
people would advise that one save so much as to put oneself into poverty or to reduce one's
living standard below some reasonable norm. Excessive prudence can seem inappropriate as
well.
Case 4 Evaluation
The prime example of a country that mimics the first period of case four is Japan during the
1980s and 1990s. Japan ran sizeable trade surpluses during those two decades. As this story
suggests, the flip side of the trade surplus is a financial account deficit which implied a
considerable increase in the amount of loans that Japan made to the rest of the world. Although
Japan's trade surplus has often been touted as a sign of strength, an important thing to keep in
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mind is that Japan's trade surpluses implied lower consumption and government purchases, and
thus a lower standard of living than would have been possible with balanced trade. Although
trade surpluses can also result in lower investment, this effect was not apparent for Japan. During
those two decades investment spending as a percentage of GDP always exceeded 25%, higher
than most other developed countries.
These surpluses may turn out to be especially advantageous for Japan as it enters the 21st
century. First of all, it is clear that Japan's surpluses did not usher in an era of continual and rapid
GDP growth. By the early 1990s Japan's economy had become stagnant and finally began to
contract by 1998. However, rather than allowing a decline in GDP to cause a reduction in living
standards, Japan can use its sizeable external savings surplus to maintain consumption at the
level achieved previously. Of course this would require that Japan increase its domestic
consumption and begin to run a trade deficit; two things which in 1998 do not seem to be
occurring.
In another respect Japan's trade surpluses may be advantageous over the longer run. Japan, along
with most other developed nations, will experience a dramatic demographic shift over the next
three decades. Its retired population will continue to grow as a percentage of the total population
as the post-world war II baby-boom generation reaches retirement and because people continue
to live longer. The size of the Japan's working population will consequently decline as a
percentage of the population. This implies an increasing burden on Japan's pay-as-you-go social
retirement system as a smaller number of workers will be available per retiree to fund retiree
benefits. If at that time Japan draws down its accumulated foreign savings and runs trade deficits,
it will be able to boost the average consumption level of its population while reducing the need
to raise tax burdens to fund its social programs. Of course this outcome may never be realized if
Japan's economy does not rebound strongly from its recent stagnant condition.
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All in all, regardless of the outcome, Japan's economy, today faced with a potentially severe
recession, is certainly in a stronger position by virtue of its accumulated foreign savings than it
would be if it had run trade deficits during the past two decades.
CASE STUDY
Agriculture Is Amazing
“I don’t want to hear about agriculture from anybody but you . . . Come to
think of it, I don’t want to hear about it from you either”-President Kennedy
to his top agricultural policy adviser. Agriculture is another world.
Sometimes it seems as if the laws of nature have been repealed.
From the late 1980s to the late 1990s, the desert kingdom of Saudi Arabia grew more wheat
than it consumed, so it was a net exporter of wheat.Wheat is exported by other countries
with unfavorable soils and climates, including Great Britain and France. And crowded,
mountainous Japan has often been a net exporter of rice.
All this happens because governments are more involved in agriculture than in any other
sector of the private economy. In 2012 government policies in industrialized countries provided
about $259 billion of support to farmers,equal to about 19 percent of farmers’
revenues.Government policies in the European Union(EU) provided $107 billion (19 percent of
farm revenues), in the United States $30 billion(7 percent), and in Japan $65 billion (an
amazing56 percent of the revenues of Japanese farmers).
The farmers’ political lobbies in these countries are remarkably powerful, especially relative
to the small role of agriculture in the economy (only about 2 percent of gross domestic
product). Farmers producing rice, milk, sugar,and beef are the biggest recipients of these
subsidies.Close to half of the increased farm income is provided through price supports. For the
typical price support, the government sets a minimum domestic price for the agricultural
product, and the government buys any amounts that farmers cannot sell into the market at the
minimum (support) price.
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Domestic farmers receive at least the minimum price when they sell, and domestic
consumers pay at least the minimum price when they buy. All of this sounds domestic—
domestic minimum price, domestic farmers, domestic consumers. Yet something that starts
“domestic”transforms itself on the way to the global markets.The support price is almost always
higher than the world price for the agricultural product. If the country would import the product
with free trade, the price support requires that imports be restricted.
Otherwise, cheap imports would flood into the country and undermine the price support. If
the support price is not too high (less than or equal to the no-trade price for the country), then
the price support is actually a form of import protection. Interesting, but not amazing yet. If
the country would export the product with free trade, but the support price is above the world
price, then the country’s farmers produce more than is purchased by domestic
consumers.The government must buy the excess production at the high support price.
The government could just destroy what it buys or let it rot, but that would be
remarkably wasteful. The government could give it away to needy domestic families, but there
are limits to how much can be given away before this free stuff starts to undermine regular
domestic demand. The government could turn to the export market, which sounds like an
excellent way to dispose of the excess national production.Perhaps it is, but the government will
take a loss on each unit exported. This loss, the difference between the support price that the
government pays and the lower world price that it receives, is an export subsidy from the
government.
Foreign buyers will not pay the high domestic support price; they buy only if the
government offers a subsidized export price. In this case, in which an exporting country sets a
support price that is above the world price for the product, the price support policy is actually a
combination of import protection and export subsidy. We are getting closer to amazing. Price
supports can also switch agricultural products from being importable to being exported . Wheat
is an example for Britain, France, and other EU members. Butter and other dairy products in the
EU are other examples of products that have become exports because of generous price
supports. With free trade, wheat, butter, and other dairy products would be imported into the EU
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because the world prices of these products are lower than the EU’s no-trade prices. (More
simply, the EU has a comparative disadvantage in these products.)
The EU’s support prices are so high that EU farmers produce much more than is sold in
the EU.The EU uses export subsidies to export some of its excess production. Now that’s
pretty amazing. Domestic price supports morph into a combination of import protection and
export subsidies that transform the country from an importer to an exporter of the products.It
takes a lot of government money to create amazement. The EU’s Common AgriculturalPolicy
(CAP) covers a broad range of agricultural products (including wheat, butter, and other dairy
products).
CAP spending represents over 40 percent of all EU fiscal expenditures. And the
amazement brings a large national cost. The inefficiency of the CAP is equal to a loss of about 1
percent of the EU’s gross domestic product.Agriculture has also been another world forWTO
rules. In contrast to the rules for industrial products, governments had been permitted to use
import quotas and export subsidies. But things are changing.
The agricultural provisions of the Uruguay Round trade agreement made agriculture
less different, especially for developed countries. Governments converted quotas and other non
tariff barriers into tariff rates, a process called tariffication . Each developed country reduced
its budget outlays for export subsidies by 36 percent and its volume of subsidized exports by
21 percent. Each developed country reduced its domestic subsidies to agriculture by 20
percent, with exceptions. The requirements for developing countries were less stringent.
The effects of these changes are not as large as one might expect. Most developed countries
have maintained import protection through artful implementation of the agreement.
Generally,highly
protected products remain highly protected.The reduction of export subsidies has had
some impact, especially in reducing subsidization of exports by the EU.
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The effects of the general reduction in domestic subsidies are moderate because major
subsidy programs in the United States and the EU were exempt from the cuts. After the Uruguay
Round agreement, agriculture is becoming less different.
One way is that tariffication has placed import barriers into a form in which they can
be compared across countries.
A second way is that there is now pressure to reduce the use of subsidies in agriculture.
Countries can use the WTO dispute settlement process to examine excessive
agricultural subsidies.
Decisions in 2005 in two major cases—EU export subsidies for sugar and U.S. subsidies
to cotton—found subsidies that violated WTO rules and agreements.
The Uruguay Round agreement also laid the groundwork for negotiations during the current
Doha Round that are aimed to achieve more substantial liberalizations. In this sector that
would be amazing.
DISCUSSION QUESTIONS
With help of trade theories, concepts and illustrations, discuss the following questions in detail.
Q1. For the European Union, can a tariff or import quota turn butter into an EU export
product? If not, why can price support turn butter into an EU export product?
Q2. Explain how Uruguay Round helped make Agriculture less different for developed
countries?
Q3. Discuss the facts and implication of the WTO decisions in the cases of EU export subsidies
for sugar and U.S. subsidies to cotton?
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Q4. For a large agrarian country like India what is the best policy to shape its agriculture sector
keeping in mind the WTO rules?
ANSWERS
ANSWER-1
Foreign buyers will not pay the high domestic support price; they buy only if the
government offers a subsidized export price. In this case, in which an exporting country sets a
support price that is above the world price for the product, the price support policy is actually a
combination of import protection and export subsidy. With free trade, wheat, butter, and other
dairy products would be imported into the EU because the world prices of these products are
lower than the EU’s no-trade prices. The EU’s support prices are so high that EU farmers
produce much more than is sold in the EU.The EU uses export subsidies to export some of its
excess production. Domestic price supports morph into a combination of import protection and
export subsidies that transform the country from an importer to an exporter of the products.It
takes a lot of government money to create amazement. The EU’s Common AgriculturalPolicy
(CAP) covers a broad range of agricultural products (including wheat, butter, and other dairy
products).
ANSWER-2
The Uruguay Round was launched in 1986 by the Punta del Este Declaration, in which the
negotiating objectives of the Round were laid out. The objectives with regard to agriculture were
described as follows:
"to achieve greater liberalisation of trade in agriculture and bring all measures
affecting import access and export competition under strengthened and more
operationally effective GATT rules and disciplines"
An important element of the declaration was its explicit recognition of the effects that domestic
agricultural policies have on trade. The Round would concentrate not only on the issue of border
controls and export subsidies, but also on a broad range of domestic agricultural policy issues.
Policies that subsidised producers would be subject to close scrutiny and negotiation. The
principal mechanism for progress on trade liberalisation within the GATT have been periodic
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multilateral negotiating rounds. In all, there have been eight such rounds, starting with the
Geneva Round of 1947 that established the GATT, and concluding with the Uruguay Round that
ended in 1994 after having established the WTO. The primary focus of the majority of rounds
has been promotion of multilateral tariff reductions, and the extension of the agreed reductions to
all members in accordance with the MFN clause.
ANSWER-3
Acting on complaints by Brazil, the World Trade Organization (WTO) adopted in Spring 2005
two dispute settlement reports that not only require changes to U.S. and European agricultural
subsidies, but alter the balance of concessions reached in the 1994 Agreement on Agriculture,
further complicating the task of tightening agricultural disciplines underway in the Doha
Development Round. The Cotton report reclassifies from the green box (permitted subsidies) to
the amber box (subject to reduction commitments) two U.S. programs whose payments are based
on historical acreage and yields and thus were thought by most observers to be decoupled both
from price and production, the archetypal exemption from reduction commitments for non-trade
distorting subsidies. The panel concluded that the so-called "fruit and vegetable exception,"
which results in reduced payments if the grower plants certain crops, was sufficient to link
payments to production, despite evidence that virtually all cotton recipients would in any event
have continued to plant cotton on their base acreage. The panel went on to find that subsidies to
cotton producers exceeded the U.S. reduction commitment in the Agreement on Agriculture and
caused world cotton prices to be "significantly suppressed," an actionable form of injury to
Brazil's cotton exporters under the WTO Subsidies Agreement. We conclude that it is difficult to
argue with the Panel's finding that price support programs tied to world prices have market
insulating effects on farmers and a negative impact on world cotton prices. However, even in the
absence of U.S. cotton policy, world cotton prices may be distorted from widespread use of
subsidies by other cotton-producing nations. As a result, the Panel's statements concerning price
suppression in the absence of U.S. cotton policy should be interpreted with caution, because
price suppression can exist even in the absence of the U.S. cotton policy. Even more importantly,
the Panel's failure to quantify either the magnitude of the subsidies or the nature of the price
effects leaves governments without a road map to conform their agricultural support programs to
these strict-liability interpretations of WTO mandates. The EC sugar regime establishes
production quotas for two categories of sugar, labeled "A sugar" and "B sugar." These are the
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maximum amounts of sugar that may be sold within the EC in a given year. Producers must
export any surplus amounts, designated "C sugar." Domestic prices for A and B sugar are
supported by an array of government measures and also receive direct export subsidies. EC sugar
producers receive no additional funds from the EC if they export a large amount or no C sugar.
The Sugar panel found that "A, B or C sugar are part of the same line of production and thus to
the extent that the fixed costs of A, B or C are largely paid for by the profits made on sales of A
and B sugar, the EC sugar regime provides the advantage which allows EC sugar producers to
produce and export C sugar at below total cost of production." The Sugar panel's finding that
below-cost exports of an agricultural product may, even in the absence of "direct" export
subsidies, represent proof of export subsidization if there is close linkage between these exports
and domestic support programs makes the U.S. rice, corn, soybeans, and other commodities
programs vulnerable to dispute challenge. The finding also substantially complicates the EC's
task of bringing its sugar regime into compliance with its reduction commitments under the
Agreement on Agriculture. If the 4 million tons of "C sugar" exports benefit from prohibited
"export subsidies," either these exports must be eliminated or their subsidization must be ended.
The former approach will put the EU in breach of its agreements with ACP countries and with
India. The latter will be difficult, if possible at all, without elimination of domestic support for
"A" and "B" quota sugar, because the Sugar opinions leave the EC with little guidance as what
level of domestic support would end "C" sugar cross-subsidization. As in the Cotton case, the
lack of quantification has left the losing WTO Member in a position of not knowing how to bring
its subsidy program into compliance. Using both subsidies law and trade economics, we argue
that these decisions markedly change the starting positions in the Doha Round by blurring
distinctions between the "boxes" that were clear to agriculture negotiators during the Uruguay
Round, as well as distinctions between domestic and export subsidies crucial to the balances
struck in the Agreements on Subsidies and on Agriculture. No matter how destructive of efficient
markets large subsidies may be, these cases should not be seen as proof that developing countries
can bring to justice rich nations that abuse their financial power to cause injury. The cases simply
demonstrate that an agricultural superpower can take advantage of technical traps caused by
imprecise drafting and an increasingly literal WTO dispute settlement system with a built-in bias
against deference to national agencies to penetrate its most desirable markets.
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ANSWER-4
Land reforms not only contribute to higher productivity but also brings social justice. It entails a
redistribution of the rights of ownership and/or use of land away from big cultivators or jotedars
and in favour of small cultivators with limited or no landholdings.
The following land reform measures have been taken in India after independence:
(b) tenancy reforms comprising rent regulation, security of tenure and conferment of ownership
rights to tenants,
(c) ceiling on landholdings and redistribution of acquired landholdings by the state among the
landless workers and small farmers.The twin objectives of land reform policy were higher
agricultural growth rate and social justice so as to abolish exploitation of the tenants.
During 1950-65, Indian agriculture had been shaped by public investment in agriculture with the
objective of achieving self-sufficiency in foodgrains. Such public investment concentrated in the
construction of irrigation reservoirs, distribution systems.
In spite of the land reform measures undertaken in the early decades of planning, the country
faced severe food crisis resulting in huge import of foodgrains. Necessity was felt to introduce
technological measures to raise agricultural production and productivity in the quickest possible
time. During mid-60s to 1990, Government strategy in agriculture evolved around incentive
policies for the adoption of modern technology in agriculture coupled with public investment
policy.
In the mid- 1960s, the Government of India adopted a new agrarian strategy which goes by
different names—seed-fertiliser-water technology, modern agricultural technology, green
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revolution, etc. It refers to the breeding of high-yielding varieties of wheat and rice and the
introduction of modern technologies so as to achieve a sustained breakthrough in agricultural
production.
Satisfactory results have been achieved. There has been a considerable increase in production
and productivity of major foodcrops. No longer the country is import-dependent; rather, she is
now exporting some food crops. Virtual self-sufficiency in foodgrains has been achieved. This
achievement relating to productivity of Indian agriculture is described as ‘forest or land-saving
agriculture’. Truly speaking without the green revolution it would not have been possible to
achieve the state of self- sufficiency in agriculture.
Indian farmers are too poor to make arrangements for self- financing their agricultural
operations. In view of this, they rely greatly on non- institutional private sources of credit which
are exploitative in nature. In view of this, the Government of India decided to provide
institutional credit to farmers to replace the widely prevalent usurious money-lending.
Barring the creation of cooperative credit societies, commercial banks were nationalised in 1969
with the object of ensuring a smooth flow of credit to agriculturists. Regional rural banks have
also been set up to meet the credit needs. An apex credit organisation, called National Bank for
Agriculture and Rural Development (NABARD), was set up in 1982. In view of the creation of
financial institutions, the monopoly position of the village moneylender in the provisioning of
agricultural finance has been broken.
Price policy measures relating to the prices of foodgrains not only aim at increasing production
but also aim at acquiring marketable surplus, building up buffer stock of foodgrains to protect the
interests of both farmers and consumers. There are two distinct phases of India’s agricultural
price policy—one covering the period up to 1965 since independence and other covering the
period from 1965 till date. Every season, minimum support prices, procurement prices, etc., are
36
announced in a bid to provide incentive to the farmers to increase production as well as
marketable surplus.
In order to ensure adequate supplies of essential foodgrains and consumer goods such as rice,
wheat, edible oils, sugar, kerosene, etc. to consumers, especially weaker sections of the
community at cheap and subsidised prices, an elaborate food security system, popularly known
as Public Distribution System (PDS) has been built up. This is an essential element of the
government’s safety net for the poor. The PDS seeks to control prices, reduce fluctuations in
them and achieve an equitable distribution of certain essential consumer goods. It is also an
important element of anti-poverty programmes of the government. Thus, the PDS provides food
subsidy.
In addition to food subsidy given to consumers, input subsidies are provided to farmers on a
massive scale with the aim of increasing both production and productivity. Subsidies are mostly
given to inputs like irrigation, power and fertilisers. Provisioning of such inputs at prices below
the market rate not only enables improved use of inputs but also avoids food and raw materials to
go up. As a result of input subsidisation and various cross-subsidies of an astronomical height,
the state exchequer has become dry. There has now been a strong demand for cut in food
subsidies and input subsidies as these have already reached fiscally unattainable level.
We have already said about the policy developments in respect of agricultural institutional credit.
An important component of agricultural policy is the provisioning of non-farm services like
marketing including credit. Agricultural development becomes self-sustaining when additional
output can be sold in the market at a remunerative price. Policy measures relating to agricultural
marketing may be grouped into (a) setting up of marketing organisation, (b) establishment of
regulated markets, (c) provision of storage and warehousing facilities, and (d) crop insurance
scheme.
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(viii) Trade Policy:
Because of highly state interventionist and discriminating treatment against agricultural trade
before 1991, Indian agriculture had little exposure to international trade. Trade liberalisation
since 1991, however, bypassed Indian agriculture. But, towards the end of 1990s, trade
liberalisation has been faster in tune with the WTO agreements.
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BIBLIOGRAPHY
www.economicsdiscussion.com
National Digital Library
WTO website
EU Website
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