Macroeconomics class 12

Class 12

Macroeconomics

Total marks =15

1 marks 5 marks 8 marks Total
questions questions questions

21 1 15

This Chapter includes
3.1 Banking and monetary policy
3.2 Government finance
3.3 Internal trade

Banking and monetary policy

The tem bank is derive from the French word ‘Bancho’ which means a bench or money
exchange table .A Bank is a financial institution that deals with money and credit. It accepts
deposits of money from the public in different account and provides loans to the needy
persons

Role of Banking system in Economy

There are several roles of importance of banking system. Out of them, some major roles are
given below

1. Mobilizing of saving:- Banks accepts deposits and provides loan to needy person.

2 capital formation:-effective banking system help to collects saving and mobilize in productive
sectors.

3. Generation of employment opportunity:-development of banking sectors itself generate
the opportunity .Invest in the other sectors also create the opportunity.

4. Remittance of money :-banks helps to send and receive money from different parts of word.

5 .Mobilization of economy: Banking system accept deposit, invest, send and receive money
generate the employment opportunity .So banking system monetize the economy.

6. poverty alleviation :-Rural Development bank Agriculture development bank provide loan to
poor farmer women rural people in low rate of interest .Banks prevent poor from high charge
of interest .

7. Safety of wealth: the banks provide facility of custody of locker facility to the client to keep
gold, silver and others valuables

8 helps government to meet development expenditure :if expenditure of government is more
than the revenue , then government may borrow s from the banking institution to meet the
development expenditure .

Define central bank .explain the function of central bank with reference
to Nepal Rastrs bank.

Meaning of central Bank

Central bank is the supreme bank of the country .It is called the monetary authority .In every
nation , a central bank is established in order to arrange the circulation of currency
throughout the nation ,develop the financial sector and to control the credit , etc .Nepal Ratra
Bank is the central Bank of Nepal , which was established on 14th of Baishak 2013 BS

There are various regular and development functions of central bank .They are as follows

1) Monopoly of note issue: The primary function of central bank is to issues notes and coins in the country .It has
the monopoly right of issuing the notes subject to safe guards imposed by law. In Nepal ,Nepal Rastra bank
issues notes under the proportional reserve system .Till now NRB has issued the notes of Rs1,Rs2 ,Rs5,Rs10
,Rs20,Rs25,Rs50,Rs100,Rs250,Rs500 and Rs100.

2) Government banker and advisor: Central bank works as being the banker, agent and advisor of the government
. As the government banker, central bank maintains the banking accounts of all the government offices .It
advices the government to formulate different types of policies in the nation .

3) Bankers Bank : central bank also works being the bankers bank .It keeps the cash reserves of commercial banks
.All the commercial banks and other banks have their account in central bank . NRB provides the necessary
banking facilities to all the banks

4) Lender of last resort: central bank acts as a lender of the last resort. It means central bank is the ultimate source
of funding for the commercial bank .If the commercial banks cannot make payment to their customers due to
financial crisis or liquidity crisis, the central advices loan to commercial banks.

5) Provides clearing house facilities: central bank also act being the settler of the financial claims of a bank with
others . The central banks clears each other’s claims from their respective accounts

6) Control of credit : credit is created by commercial and other banks and it is controlled by central bank . Excess
credit creation results inflation and too less credit results deflation . so, the central bank controls the credit by
using bank rate policy , open market operation and changes in the statutory reserve requirement of banks .

7) Foreign exchange control: central banks of all the nation have absolute right to regulate the foreign exchange
.The foreign exchange rate is determined by demand for and supply of foreign currency under flexible exchange
rate regime like wise , the exchange rate is determined with mutual agreement under fixed exchange rate
regime.

8) Custodian of foreign currency and metallic reserve : The central banks keeps and manages the foreign exchange
and metallic reserves like :god silver etc.

9) Development functions: it includes following
 Central bank helps to develop financial market
 It collects the data related tom money , banking and real sectors to make policies
 It helps to promote agricultural sector
 Promotion of foreign trade by providing foreign currencies
 Maintain the relation with international and financial institution

What is commercial bank ? Explain the function of commercial bank with reference to Nepal.

Commercial bank is a financial institution established in order to earn profit doing its
business. Oldest commercial bank in Nepal is Nepal bank limited.

function of commercial bank

a commercial bank perform variety of function and plays an important role in the process of
economic development .Function of commercial bank s are cauterized into

1. primary function 2. secondary function 3. contingent function.

Primary function of commercial bank are

a)accepting deposits:-commercial bank accept deposits from general public in three types:

i)demand deposits :deposits which can be withdrawn on the demand of account holder is
called the demand deposits. Depositors deposit heir money just for security sake rather than
earn profit.

Ii)Saving deposits: account in which bank provide the smack rate of interest and deposits can
withdraw the money on demand up to certain amount under certain condition .Deposit on
such account is called saving deposit.

ii)fixed or time deposits: deposits which is deposits for fixed period of time is called fixed
deposits. Depositors gets higher interest rate than saving deposits but if the depositors liked
to withdraw before the maturity period ,the bank levies some charge to the depositors.

b)providing loans :- he next important primary function of commercial bank is to advance loan
for the commercial purpose to businessmen traders producer etc. Bank charge a higher rate of
interest to lender than to the depositors .The difference of interest between the deposits and
lending is income of bank .Types of loan provided by commercial bank are:

i)Cash credit :commercial banks provide cash loan by keeping valuable security collateral.
Banks open account on deposits the loan money.

ii)over draft :under this facility costumers are allowed to withdrawn more than their deposit
by charging certain rate of interest on overdraft amount.

iii)discounting bill of exchange: under this scheme ,the bill holder may use the bill as collators
to get loan in case of financial problem. Before the time to their maturity ,businessmen can
get the loan on the basis of their bills of exchange.

c)credit creation :credit creation means to provide the loan to the business traders and
entrepreneurs by opening their account in own bank .While sanctioning the loan to a
borrower ,a bank does not provide cash money rather open an account in the name of
borrower and deposits that loan in the account.

2)Secondary functions:

a) Remittance of money :sending and receiving money from one place to another place within
country and outside the country is called remittance of money.

b) purchase and sale of securities: the commercial bank may purchase and sale of securities
like shares debentures bond etc. on request of their customers.

c)act as trustee: competitive banks facilitate the function like booking the travel ticket, utility
bill payment ,receiving payment etc. on behalf of the customers .

3. contingent function

a)safety of valuable goods :commercial banks provides safety of valuable goods like gold silver
,diamond.

b)issues credit instruments :commercial banks perform the function of issuing various credit
instrument like draft letters of credit ,traveler’s cheque , master card and so on.

c)foreign exchange operation :the commercial banks deal with foreign currency exchange
operation under direction of central bank.

4)publication :-the commercial banks publish their information on daily ,monthly and yearly
bulletins to show their financial status to the central bank ,customers and general public.

Concept of money market and capital market

A market mechanism which deals about short term and long term lending and burrowing of
financial instrument is called financial market. financial market carries the transaction of
money cheque ,treasury bill, government securities. This market can be classified into money
market and capital market.

Difference between money market and capital market .book page152

What is monetary policy? What are its types?

Monetary policy is government’s macroeconomic policy which is carried out with help of
central bank. In monetary policy ,economic activities like aggregate demand are influence by
the help of money supply and interest rate.

There are two types of the monetary policy

a) Expansionary monetary policy : It is also called easy or loose monetary policy. This
policy increase money supply reduce rate of interest to increase aggregate demand .In

this policy government increase expenditure to reduces the rate of tax .It stimulates
consumptions investment and economics activies
b) Contractionary monetary policy: it is called light monetary policy . In this policy decrease
money supply increase rate of interest . Government increase tax rate decrease
expenditure .It control the inflation .

What are the objectives of the monetary policy?
 To promote higher economic growth.
 To increase higher level of employment opportunities
 To stabilize domestic price and interest rates.
 To stabilize the financial markets
 To stabilize external sectors (BOP, foreign exchange reserves and exchange rate)

Explain the instruments of monetary policy
Instruments of monetary policy are the tools to control and regulate the money supply cost
and availably of credit . instruments of monetary policy are

a) Quantitative instruments
i) Case reserve ratio(CCR) :- all the banks have account in central bank. Certain percent’s

of their deposit should in the form of reserve with central bank . Such reserve is
known as CCR . In higher CCR the credit creation of bank decrease .So , money supply
decrease in market .In low CCR the credit creation of bank increase. Money supply
also increase
ii) Open market operation : Open market operation means selling and buying the securities
of government. In excess liquidation (money) central bank sells the government’s
securities . In low liquidation on market central inject the money by purchasing the
securities from the bank and the public
b) Qualitative(selective instruments)
i)Directed credit program :- such types of instruments are design for promoting backward or
deprived sectors of economy .This types of instruments offers special privilege on credit
and discount on interest rate facility .In Nepal this program is completely phase out since
fiscal year 2064 /65 At present their exist a mandatory provision for deprived sectors
ii) Change in margin requirements: central bank can influence money supply by changing
margin requirement of collateral
iii) Regulation consumer credit: central bank can influence money supply by setting limit
on down payment or by changing repayment duration

iv) Moral suasion : It is moral and indirect psychological pressure of central bank to the
commercial bank .Central bank can request or force all financial institution to work in line
with sprite of policy it has undertake . Central bank can arrange round table agreement
and make gentlemen agreement on contemporary issues and financial matter.

Unite:-Government finance

Meaning:-public finance ,which is also called government finance ,is related to the dealing of
government income and expenditure as well as financial administration and control .Parts of
public finance are :i) public finance ii)public revenue iii)public debt iv)budgeting etc.

Public finance is both the science and art because it formulate principle and polices the
implement those policies and principles effectively to solve the problems related to an
economy through the financial measures.

Importance of public finance

The major roles or importance of public finance are given below.

1. To minimize the disparity in living
standard.

2. To maintain economic stability.
3. Economic development.
4. To increase agriculture and

industrial production.
5. To achieve favorable balance of

payment.

What is Government expenditure? Explain its importance .
The expenditure made by different sectors for welfare of public is called public
expenditure or government expenditure.

Importance of government expenditure

a)Perverse and promote the national identity:- government expenditure is
require d to maintain peace ,law and order. The expenses in security are
equally essential to protect the country from external intervention .Public
expenditure help to preserve the national sovereignty and democracy.

b) Development of infrastructures:- government expenditure is needed to
develop the economic infrastructure like electricity ,irrigation, communication
agriculture industry transports and energy sources. It equally important to
develop the social infrastructures like education, health nutrition supply law
and security .similarly it also helps to improve human capital.

c)Economic growth:-government spends in agriculture ,industries trade and
commerce which help in achieving the yearly target of economic growth .
similarly, the government also invests in public enterprises to produce socially
desired goods and services which also enhance the economic growth

d) Reduction in income inequality:- By providing subsidies in the goods that are
mainly used by the poor , the government can reduce the income inequality. I
t provides the incentive to underprivileged people. Government expenditure
in education health ,sanitation law and order and peace and security also
reduce income inequality and increase social welfare.

e)Reduction in regional disparity:- government expenditure on the basis of
necessity of community and potentiality of natural resource reduce tin
disparity .

f) tackle the business cycle:- government investment is needed to give pace to
economic activities during the stages like recession and depression of business
cycle .It help to increase employment opportunity to the people which in turn
help to increase demand in the market.

7)other services:- government has to manage expense for administrative cost
related to social activities including population control ,housing and

habitation program, sanitation ,health etc. similarly the government also set
up emergency funds to support for natural calamities

Classification of government

Current expenditure :current expenditure is the regular expenditure incurred to
run or operate authorities and programs.

Capital expenditure :the expenditure that is done for the production and
promotion of goods and services is called capita l expenditure that id done for
the production and promotion of goods and services is called capital
expenditure. For example mechanical equipment building factory machine etc.

Heading of government expenditure in Nepal are: constitutional organs,
general administration revenue administration economic administration and
planning, judicial administration, defense, social and services miscellaneous.

Public revenue
The revenue collected by the government from different sources within one
fiscal year is called public revenue .The source of public revenue are :i)tax
revenue ii)non tax revenue iii)foreign assistance/grants.

Costumes ,tax on production and consumption of goods and services ,’tax on
property and profit ,registration tax etc are the tax revenue. Fee license and
permits ,fines income from public proprieties and public enterprise etc are the
non tax revenue.

Tax

Tax is the compulsory monitory charge imposed by government for its citizens
and institution for the services provided in different sectors. The tax payer
doesn’t get immediate benefit from tax payment. However they get indirect
benefit in the field of the health education transport drinking water and many
more. Tax is the major source of government resource. There are two types of
taxes: direct and indirect tax.

What is direct tax ? Explain its merits and demerits .

Book page 362 Q(21)

What is Indirect tax ? Explain its merits and demerits ?
The tax which is impose on one person or institution but its burden con be
shifted to another person is called indirect tax. Burden of indirect tax can be
shifter on person to another person. For example VAT sale tax, custom duty
etc.

Advantages/merits of indirect taxes
The merits of indirect taxes are :

1)convenient: -indirect tax are imposed on production ,sale and movement of
goods and service .Amount of tax is added on price of goods and service by
producer and sellers. So such tax is paid unknowingly paid on purchase of
commodity or enjoyment of a service. The tax payers should not bear extra
burden to keep record of indirect tax. Government collects lump sum from
manufactures or traders at once but tax payers pay in small amount in interval.

2)difficult to evade:-indirect tax is almost impossible to evade or cheat the
payment of indirect tax because it is included in the price of goods and
services. The consumers ,who purchase goods and services must pay tax.

3)wide coverage:-indirect tax is imposed on goods and services and include in
their prices. All the consumers pay tax because the purchase goods to
consume and to live. So indirect tax is paid by rich and poor consumers from
the society.

4)Elastic :-some of indirect taxes like customs duty are elastic in nature. when
government feel it necessary to increase its revenue ,it increase these taxes. In
times of prosperity indirect taxes produce huge revenue to the government.

5)influence the pattern of production:-by imposing high tax on luxurious goods
and low tax on necessary goods government can achieve better allocation of
resource and influence on pattern of production. So indirect tax is progressive
in nature.

6)social welfare: government impose high rate of tax on production and
consumption of harmful production such as alcoholic products tobacco etc.
The revenue so collected is in social welfare programs. Government also use
such fund for the development of infrastructure like; road transport
communication health post schools collage universities and so on. It maintain
the social value and norms.

Disadvantage of indirect taxes

1)high cost of production :-indirect tax is imposed on the goods and services.
Government should spend more resource and manpower to set up effective
mechanism for collecting tax .So ,indirect tax is expensive tax system.

2) increase income inequality : indirect tax is paid by taxpayer while purchasing
goods and services .The price of goods and services are same for rich and poor
people. This may further increase the disparities among the rich and poor. In
this sense, indirect tax is regressive in nature.

3)Affect consumption:--imposition of indirect tax increase the price of goods
and services. It affect consumption ,saving investment in economy. So this tax
system is unproductive in nature.

4)Lack of social consciousness :-indirect tax is impose on goods and service
.consumers feel that they are paying price of services. So they do not feel the
burden of taxes they pay. Hence indirect tax can’t create social consciousness
as direct tax.

5)uncertainty:-indirect tax increase the price of goods and services. Consumers
may not buy expensive goods and services .In this situation , collection of tax is
uncertain.

6) Inflationary: indirect tax is inflationary because indirect tax increase price
of goods and services.

7)Possibility of tax evasion: consumer and seller may exchange goods and
services without bill which may evade the tax.

Differences between direct and indirect tax

Direct tax Indirect tax
Its burden can’t be shift to others Its burden can be shift to others
It is imposed on income profit It is imposed on goods and services
interest.
It is progressive in nature It is regressive in nature.
It is based on principal of ability to It is imposed equally to all classes of
pay people.
It has narrow scope It has broad scope
It is difficult for taxpayers It is easy for taxpayers
It does reduce the sprite of tax It does not reduce the sprite of tax
payers payers
It ensure equality on the society It causes in equality on the society.

Proportional progressive, regressive and digressive tax

Proportional tax system: if same rate of tax is imposed to rich and poor tax
payers, it is called proportional tax system. for example ,

Level of income(Rs) Rate of tax

10,000 5

20,000 5

Progressive tax system: if rate of tax increase with the rise in level of income

,it is called progressive tax system. for example ,

Level of income (Rs) Rate of tax( in%)

10,000 2

20,000 4

30,000 6

Regressive tax system: if low level of tax is imposed to rich people and high

level of imposed to poor people, it is called regressive tax system.

Level of income(Rs) Rat of tax(in %)
10,000 6
20,000 4
30,000 2

Digressive tax system: if the rate of tax increase up to certain level of income
and the rate remains fixed thereafter, it is digressive tax system. For example,

What are the Characteristics of good tax system ?
Tax is major source of government revenue .Development and economic
transformational so depend upon the tax system. A tax system is caller good if
it does not reduce the sprite of taxpayer and production and adverse effect on
economic activities .The features of good tax system can be summarized in the
following points.

1)cannon of ability or equity: tax system be bases on equity of sacrifice .Rich
people have high ability to pay and poor have low ability to pat .So the rate of
tax should be high for rich people and low for poor people which cause equal-
marginal burden.

2)cannon of certainty : A good tax system should have their feature of
certainty about amount of tax to be paid time of tax payment place of tax
payment etc.

3)Cannon of convenience: A good tax system should be convenient for the
taxpayer .The time and date of tax payment should be according to the
convenient of tax payer for example for salary earners at time of receiving
salary ,for consumers at time of buying for farmers at time of harvesting
period.

4)cannon of uniformity :A good tax system should be applicable to all the
citizens of the country according to their financial status. Ac common rule
should be applied to the taxpayers keeping their economics status. The tax
system should not discriminate the tax payers.

5)cannon of simplicity :-A good tax system should be very simple to
understand. All the information regarding the payment should be transparent
and information should be written n a simple language which is able to avoid
corruption and confusion.

6)Cannon of diversity :-The tax system is said to be good if it has broad base of
tax collection. The tax system should identify new area of possible tax

collection. It is better to impose small tax under different heading than
imposing high rate under one heading.

7)cannon of elasticity :-A tax system should be flexible and elastic in nature to
meet the increasing demand for government expenditure.

8)Cannon of popularity:-A tax system is said to be good if it is popular among
the tax payer .It means it must be liked by all the tax payer and the burden of
taxation must be very less .In such case everyone is ready to pay tax to
government to government.

9)cannon of economy : The government must take care of maximizing the tax
revenue by spending less administrative cost .Tax system must increase the
welfare of nation.

10) cannon of productivity :The tax system which does not reduce the
purchasing power of consumers and producing capacity of producer is caller
good tax system. Government should impose business friendly tax rate to its
tax payers. It should not harass and high burden for tax payer.

Public burrowing

The money or fund taken by the state in forms of loan from different sources s
called public borrowing .It is also caller government borrowing. The fund taken
by the country must be repaid with interest after he maturity period. The
major objectives of public borrowing areas follow.

I ) to meet budget deficit ii)to meet war expenses ii)to control inflation

iv)to solve the problem of unemployment and depression v)to develop
infrastructures

Source of public borrowing or debt.

There are two broad source of public borrowing i) internal and external
borrowing .Market borrowing and non market borrowing are internal
borrowing. Bilateral and multilaterals borrowing are international borrowing.

What is Government budget? Explain process of budget formula
The word budget is derive from French word ’Baguette’ which means a leather
bag. But budget is a document that contains estimation of government income
and expenditure for one fiscal year. Budget is also called the major financial
plan for public spending .There three types of budget. They are deficit budget
surplus budget and balance budget. The process of budget formulation can be
explain under the following heading

a)estimation of overall expenditure and expenditure: It is the first step of
preparation phase. At this step, the budget units of the ministry of finance
provide budget form to all concerned ministry. They fill the form and return to
the ministry of finance showing the estimation of expenditure and potential
income. Finally budget unit estimate overall expenditure and income.

b)determination of priorities : As the resources committee sets the targets of
expenditures .The budget units of MOF determines priorities according to
need of development, past experience ,present condition of the sectors and so
on.

c)preparation and selection of new projects: On the basis of Determined
priorities , new projects from different sectors are select and purpose to
planning commission for their feasibility study .On the basis of priorities and
recommendation of planning commission new project are select.

d) discussion : the discussion program me take place among the
representative of budget unit of ministry of finance ,ministry of finance,
member of planning commission ,secretaries of other ministries ,professors of
economics various export ,representatives of the private sectors ,donors etc.
The conclusion derived would be guideline for finance minister

e) final document: The budget document is prepare before one month of new
fiscal year .The finance minister preset the budget in the house .It should be
passed by majority members after discussion in parliament

f) Authorization and implementation: The legislature authorizes the budget
and it becomes an act . then the budget begins to disburse in concerned fields.

.

International trade

International trade also called the foreign trade which include the
transaction of goods across the frontier of nation .it involve the import
and export of goods .

Role or importance of international trade

The main roles of international trade are as below
1) Proper utilization of resource: through the international trade, nation

specialized in producing those goods in which the have grate
comparative advantage. each country always tries to allocate the
available resources properly and efficiently.
2) Benefit of specialization: there is great chance of specialization and
division of labor due to international trade. Every country can
produce those goods which have more comparative advantage. In
such case production increase with quality goods and compete in
international market by achieving benefits in specialization market by
achieving benefits in specialization.
3) Benefit to the consumer: foreign goods which are not produces
domestically because of higher production cost and other reason are
easily accessible in international market. so, the consumer can take
and enjoy by consuming them in both least cost and high quality.
Similarly, it helps to control crises of goods and service by importing
necessary goods from other countries too.
4) Economic development: due to the internal trade. Goods are produce
by effective utilizations of resource with specializations of labor and
new technology. On the other hand consumer gets cheap and quality
goods. In, this way overall economy of nation will be developing.
5) Good relations with foreign countries: International trades develop
interdependent among countries which force to develop worldwide
brotherhoods. Interdependent with competition also helps to boost
up efficiency, capacity of world economy.
6) Increase in employment and income : international trade provides
plate form for production of good, specialization of resource .It
increase in employment opportunities in other sectors including

industries and service sectors ( insurance , banking transport and
communication)
7) Promotes competition : international trade promote competition
among the countries inside the countries
8) Assistance during natural calamities: during natural calamities such as
earth quakes floods famine etc. Affected countries face the problem
of shortage of essential goods. Foreign trades enables countries to
import food grains and medicines from other countries t help the
affected people.
9) Market expansion : foreign trade helps to explore market for local
product in international arena.

What is free trade What are the advantage and disadvantages of Free
trade ?
The concept of free trade was developed by classical economist. Free trade
refers to free and unrestricted moment of goods and service between different
countries in the world. So, under the free trade policy all kinds of artificial
control on international trade such as tariffs , quartos , licensing, system are
absent .advantages are same an role of international trade

Advantages of free trade

1) Proper utilization of resource: through the international trade, nation
specialized in producing those goods in which have grate
comparative advantage. each country always tries to allocate the
available resources properly and efficiently.

2) Benefit of specialization: there is great chance of specialization and
division of labor due to international trade. Every country can
produce those goods which have more comparative advantage. In
such case production increase with quality goods and compete in
international market by achieving benefits in specialization market by
achieving benefits in specialization.

3) Benefit to the consumer: foreign goods which are not produces
domestically because of higher production cost and other reason are
easily accessible in international market. so, the consumer can take
and enjoy by consuming them in both least cost and high quality.

Similarly, it helps to control crises of goods and service by importing
necessary goods from other countries too.
4) Economic development: due to the internal trade. Goods are produce
by effective utilizations of resource with specializations of labor and
new technology. On the other hand consumer gets cheap and quality
goods. In, this way overall economy of nation will be developing.
5) Good relations with foreign countries: International trades develop
interdependent among countries which force to develop worldwide
brotherhoods. Interdependent with competition also helps to boost
up efficiency, capacity of world economy.
6) Increase in employment and income : international trade provides
plate form for production of good, specialization of resource .It
increase in employment opportunities in other sectors including
industries and service sectors ( insurance , banking transport and
communication)
7) Promotes competition : international trade promote competition
among the countries inside the countries
8) Assistance during natural calamities: during natural calamities such as
earth quakes floods famine etc. Affected countries face the problem
of shortage of essential goods. Foreign trades enables countries to
import food grains and medicines from other countries t help the
affected people.
9) Market expansion : foreign trade helps to explore market for local
product in international arena.

Arguments against or Disadvantages of free trade.
i. Dominates infant industries: The infant industries cannot complete

with the imported goods in terms of price and quality as they lack the
economies of scale.
ii. Unhealthy competition In free trade each and every country is
encouraged to increase export and there is excessive competition in
production and sales. As a result it invites unhealthy competition
among the countries in under developed country.

iii. Creates dependency: Due to the one sided or imbalanced industrial
development in economy. It increases dependency of developing
countries on developed countries. It reduce the capital formation of
under developed countries.

iv. Possibility of unemployment : Developed country use capital
intensive production technology to produce quality, quantity of
goods. But under developed country cannot run industry by
competing high technology. So there is chance of unemployment in
underdeveloped country.

v. Harmful to underdeveloped country: Under developed country
cannot compete with developed country. There is a problem on
capital formation. So under developed country are supplier of physical
labour and consumer of quality goods.

vi. Trade of Harmful products: Commodities are easily exported and
imported under free trade policy , there may be high chance to trade
the goods like socially restricted or injurious or harmful goods.

vii. Effect on National Security: |There is a questions arises in the
national security in free trading
Difference between BOT and BOP( book page 200)

What is exchange rate ? Explain its types
The rate at which one unit of currency of country is exchange with the
currency of another country is called exchange rate .

Demand of foreign exchange

 To import goods and services
 To invest abroad
 To make payments among foreigners.
 To send remittance from one country to another country.
 To speculate on the value of foreign currencies

Supply of the foreign exchange:

 From exporting goods and services.
 Foreign investments.

 Foreigners gift or aid
 Income from abroad

Types of the exchange rate

Basically there are two types of exchange rate system.

1) Fixed Exchange rate system : It is also called pegged exchange rate
system. In this system exchange rate is kept constant through the
government intervention .

2) Flexible exchange rate system : It is also called floating exchange rate
system .In this system exchange rate is determined by the force of
demand and supply in the international currency market .
There is inverse relation between the exchange rate and its quantity
demand .Increase in exchange rate , decrease the import and increase
the export and vice versa.

Protection Trade or Protectionism:
The term protection refers to the policy of encouraging home industries
by giving subsidies to home products by imposing duties on the foreign goods,
by raising their prices relatively to those of domestically produced goods.
Instrument of protection are:

i. Tariff barrier : High custom duties
ii. Non tariff barrier: quota system, exchange control.

Advantage of protection policy:

i. Diversification of industries: In free trade a policy goods which yields
high profit are produce. So, through protection policy. The government
can diversity the products and industries by providing them subsidies in
the various sectors.

ii. Development of infant industries: In order to protect the domestic
industries which are just in crawling (infant) stage, the government uses
protectionism such that they get support to sustain themselves. As
these industries could not complete with the imported goods. The
policy helps them in survival

iii. Proper utilization of resources: Domestic producers are made to
produce the most of the necessary goods in this trade policy. Thus
existing resource are fully and efficiently utilized to fulfill the demand of
domestic countries.

iv. Creates employment opportunities: When industries are granted
protection, they expand and progress skilled ,semi skilled and unskilled
labour obtains additional opportunities for gainful employment new
industries also come up rapidly and new opportunities for gainful
employment are widely opened.

v. Reduces Supply of domestic currency: The protection policy
encourages its citizens to keep money or wealth at home by consuming
domestic products. When a country imports from broad its people gets
goods and foreigners get money.

vi. Balance of payment Argument: The restriction in import checks the out
flow of the foreign currencies. Similarly, Export promotion enhances the
inflow of foreign currencies. This can improve maintaining Bop of a
country.

vii. Patriotism: Purchasing the products from home country generate the
felling of national pride which is a matter of patriotism.

viii. Security Argument. Protectionism is often argued as a policy for the
national defense it is also useful to harass the foreigners who may enter
into the home country for some ill purpose rather than doing healthy
business.

Disadvantages of Protection :

i. Possibility of monopoly : As the imported goods are harassed under
this policy, there may be the complete absence of the foreign goods in
domestic market. Thus creates a chance of monopoly of the domestic
produces.

ii. Fear of dependency: Once the infant industries are given the
protection, they seek the perpetual support from the government. So
it may become difficult to withdraw the support later on.

iii. Adverse effect in Employment opportunity: Protectionism can
discourage the foreign entrepreneurs to invest in domestic production.
This lead to the increase in unemployment.

iv. Increase in income inequality. If the protection goes to the industries
run by the rich entrepreneurs, it makes rich becomes richer. This
increases income inequality and hence increases the social and
economic disparity.

v. Disputes among the countries: It can create misunderstanding among
the countries and may give rise to dispute among the countries. For
example the Nepal-Tibet war and Us-Japan war were the result of
imposing the trade barriers .

vi. Loss in consumers welfare. Protectionism puts restriction. In the
imported goods which might be of good quality AS well as cheaper
than domestic products. Also the policy discourages the competition in
the market. Hence consumes may suffer both in quality and price.

Suggest some measures to reduce trade deficit in Nepal

(page 352 question 16)

Ricardian Comparative cost theory of international trade
The comparative cost theory of international trade was introduced by

classical economist. David Ricardo at first. It is also known as Classical theory of
international trade. It is also known as classical theory of international trade.
This theory believes that production of similar goods indifferent country has
different cost of production. Thus, theory says that countries has tend to
specialize in those goods which has less cost of production and import a that
commodity which has high cost of production in domestic market. So it deal
with terms condition and direction of international trade.

Assumptions.

1)Trade takes place between two countries and two commodities

.2)Law of constant return to scale operate .

3)Labour is the only one factor of production

. 4)There is lack of transport cost.

5)Their is free trade between two countries.

6)All labours are homogeneous and equal in efficiency

7)Factors of production are perfectly mobile With in a country but they are
immobile between two countries.

It is explain with the help of following table.

Country labour hour Per unit cost of production in
Cloths
A 100 Wheat
B 90 110
80

In the above table, country A need 100 labours to produce cloth while it need
110 labour hours to produce 1 unit of wheat similarly country B need 90 labour
hours to produce 1 unit cloth and 80 labour ours to produce 1 unit wheat.
Country B has absolute advantage in both goods. But Recando has suggest that
both country can benefit by internal trade. Country ‘A’ produce 1 unit of more
clothes in place of wheat and save 10 labours hours. . Country ’B’ produce 1
units of wheat and save 10 labour hours. So ,if they specializes in particular
goods both countries get benefit

Comparative cost theory of international trade has the following
limitation.

Wrong assumption of two countries two commodity: this theory is related to
only two countries and two commodities regarding international trade .But in
fact international trade tale place between many countries and many
commodities .So the theory is restrictive for more than two countries and two
commodities.

Labour is not only the factor of production :this theory has taken into account
only the laboure cost in determination of price but in fact the cost of
production includes the cost of land ,capital and management. So labour is not
only factor of production.

Homogeneity of labour : the assumption of homogeneous units of labour is
not true .units of labour may differ in term of quality and efficiency.

Negligence of transportation cost: The theory assumes that the trade
between two country take place freely without any barrier. But in reality
international trade cannot be free due to customs duty and Quota System etc.

6. one sided theory : Comparative cost theory of international trade is one
sided theory because it has taken into two account only the supply aspect in
international trade and has completely neglected the demand aspect.

7. all factors of production are not fully mobile :According to the theory the
factors of production are perfectly mobile with in a country. But due to the
difference in wage and interest in different occupation and sectors can also
cause less mobility of factors of production.

full employment ,constant cost of production are also some other
limitation