MGT604 Management of Financial Institutions Assignment 1 Solution Fall 2014

Trade deficit embodies the situation in which imports of a country exceed its exports. It is an economic measure that represents the negative balance of trade (BOT). Economists have different viewpoints about trade deficit. Some have views that trade deficit favors the economy because GDP (Gross Domestic Product) and employment opportunities increases due to increase in country’s imports; on the other hand some of the experts criticize it strongly that trade deficit is not a good situation as it will hamper the overall economic position of the country especially in case of developing countries like Pakistan.

On the basis of analysis by experts, trade deficit is one of the major external threats for economic growth of Pakistan. It is continuously facing trade deficit and its percentage increase is quite adverse over the years. So, in developing economies, the major responsibilities lie with the policy makers as they have to consider different macroeconomic variables and need to critically evaluate them in order to improve the worse condition of trade deficit.


Being a policy maker; you are required to:

• Discuss the relationship of “Exchange Rate & Foreign Direct Investment” with trade deficit.



Foreign Direct Investment (FDI) is an international flow of capital that provides a parent company or multinational organization with control over foreign affiliates  Exchange rates, defined as the domestic currency price of a foreign currency, matter both in terms of their levels and their volatility. Exchange rates can influence both the total amount of foreign direct investment that takes place and the allocation of this investment spending across a range of countries.

The exchange rate level effects on FDI through this channel rely, on a number of basic considerations. First, the exchange rateGive logical reasons to support your suggestions.movement needs to be associated with a change in the relative production costs across countries, and thus should not be accompanied by an offsetting increase in the wages and production costs in the destination market for investment capital. Second, the importance of the “relative wage” channel may be diminished if the exchange rate movements are anticipated. Anticipated exchange rate moves may be reflected in a higher cost of financing the investment project, since interest rate parity conditions equalize risk-adjusted expected rates of returns across countries. By this argument, stronger FDI implications from exchange rate movements arise when these are unanticipated and not otherwise reflected in the expected costs of project finance for the FDI.

• Describe how to improve the negative balance of trade in Pakistan.

A balance of trade deficit exists for a country when the value of imports produced by the foreign sector and purchased by the domestic economy is greater than the value of exports produced by the domestic economy and purchased by the foreign sector. In other words, imports exceed exports and net exports are negative.

This is also commonly termed an unfavorable balance of trade because the excess of exports over imports creates a net outflow of monetary payments out of a country. This generates a decrease in aggregate income and associated measures, especially consumption, saving,investment, and tax revenue, which is rightfully considered to be “unfavorable” for the country.

A given country can have an “overall” balance of trade deficit in which imports from the foreign sector exceed exports to the foreign sector. One country can also said to have a balance of trade deficit with just one other country, in which imports from that country exceed exports to that country. For example, the United States might have an overall balance of trade surplus with the foreign sector, but a balance of trade deficit with China. An overall balance of trade deficit with the foreign sector does not necessarily mean a balance of trade deficit for every other country.