Model Answer for “India’s Strong Rupee” (May 09 HP3 Q4)
a)Import substitution is a trade policy which attempts to encourage the domestic production of goods and services by placing restrictions on imports. Thus, domestic production is substituted for imports, which, assuming that the quantity of exports remains unchanged, should result in an improvement in the trade balance.
Real GDP is the inflation-adjusted measure of the value of all final goods and services produced within a country’s borders in a given time period, usually one year.
b)The introduction of a tariff should, everything else being equal, reduce the quantity of imports into India as a tariff is, fundamentally, a tax. In general, indirect taxes like tariffs shift the supply curve to the left (or, in the case of horizontal supply curves, up) by the amount of the tax, which results in an increase in price and consequent decrease in the quantity demanded. We can show this using a diagram:
Price
Supply (domestic)
Pw + tSupply World (including tariff)
Pw Supply World (initially)
Demand (domestic)
Q1 Q2 Q3 Q4 Quantity
Observe that before the tariff was introduced, the price of imports was at Pw. Domestic Indian firms could only produce until Q1 at that price, with the remainder of sales from Q1 to Q4 being satisfied by imports. However, after the tariff was introduced, the price of imports increased to Pw + t. At this higher market price, Indian producers can produce until Q2. As the price has increased, though, the overall quantity demanded has fallen to Q3. Squeezed from both sides, the quantity of imports was reduced to the portion Q3 – Q2, which is much less than it was previously (Q4-Q1).
c)An increase in foreign direct investment into India should, ceteris paribus, lead to an appreciation of the Indian rupee as people wishing to invest in India should have to eventually buy rupees in order to do so. For instance, if an American firm wants to build a factory in India, they will need to hire labourers and buy materials in India, which will require them to have rupees. These rupees will have to be purchased on the foreign exchange market, which should increase the demand for the rupee and so increase its value. As a diagram:
Price of Rupee (US c)
Supply of Rupee on the foreign exchange market
P2
P1
Increased demand for rupees (D2)
Initial demand for Indian rupee on forex market (D1)
Quantity of rupees
Observe that the increase in foreign direct investment shifts the demand for Indian rupees on the foreign exchange market from D1 to D2, which leads to an appreciation of the rupee from P1 to P2.
d)Increased foreign direct investment in the Indian economy should have a good impact on the Indian economy. Workers, consumers and some firms will be better off, but it is possible that some firms will lose due to increased competition and other businesses will lose export markets as the rupee appreciates. Overall, it should be in the government’s interest as well to encourage FDI.
In the short-run, as the investments are being made and factories and offices are being built, Indian workers are hired and suppliers are being given business. This extra spending by foreign firms should have significant multiplier effects as well.
However, while the investments are coming into the country, it is likely that the exchange value of the rupee will rise. While this is likely only a short-term phenomenon, in the short term it could hurt Indian exporters of low-priced goods who find that their goods are being priced out of foreign markets by the rising rupee. However, if the Indian economy is developing, perhaps this would be a signal to such producers to move into the production of higher-value-added goods.
In the long-run, once the investments are made, the benefits to workers and some firms should continue. Workers employed by the foreign firms should have access to foreign technology and management practices which will increase the productivity and skills level in the economy, especially as domestic Indian suppliers to the foreign firms adopt the same practices. Rising incomes amongst workers will create opportunities for firms to increase sales and as the foreign companies grow, the opportunities for supplier firms to increase sales will also grow. For the government, rising incomes and output should translate into higher tax revenues, which can support higher spending on such things as health and education which should further propel India’s economic development.
Against this, though, some domestic firms which had previously faced little competition (as they were protected by tariff barriers from foreign firms) may find it difficult to compete against these foreign firms now on Indian soil. In the long-run, domestic competitors to the foreign firms will likely have to adopt similar technology and management practices in order to hold onto their customers, which again, while difficult for the firms, will likely be beneficial to workers and consumers.
Overall, then, the move towards increased foreign direct investment seems likely to, on balance, be beneficial to the Indian economy and so should continue to be encouraged.