MACROECONOMICS OPEN ECONOMY MACROECONOMICS

Open Economy Macroeconomics

Concept of Balance of Payments

In an open economy, consumers and firms have the opportunity to choose between the goods produced
in the domestic market and international market, investors can choose between domestic and foreign
assets and firms can choose the location and workers to produce goods. It is trading with other nations in
terms of goods, services and other financial assets. Foreign trade influences Indian aggregate demand in
two different ways. Firstly, purchase of foreign goods is a leakage from the circular flow of income which
decreases aggregate demand; secondly export to foreigners is an injection into the circular flow which
increases aggregate demand for domestically produced goods. The whole foreign trade as a proportion of
GDP is a measure of the degree of openness of an economy.

The balance of payments of a country is a systematic record of all economic transactions between its
residents and residents of foreign countries. Current account and the capital account are the two main
accounts in the balance of payments (BoP).

Current Account

Current account balance includes the export and import of goods and services and unilateral transfers
from one country to another country. Components of current account are as follows:
 Export and import of goods or visible items
 Export and import of services or invisible items
 Unilateral transfers from one country to another country
 Net value of the three balances – balance of visible trade, balance of invisible trade and balance of
unilateral transfers is recorded as balance on current account.

In the current account (BoP):

 Exports are recorded as positive items because it is the flow of foreign exchange into the country
 Imports are recorded as negative because it is the flow of foreign exchange out of the country
 Balance which occurs on account of export and import of goods is known as balance of visible trade
 Balance which occurs on account of export and import of services is known as balance of invisible
trade
 Receipts of unilateral transfers are recorded as positive items and payments of unilateral transfers are
recorded as negative items

The balance of trade is one of the components of current account balance. Balance of trade means
balance occurs on account of export and import of visible items.
Balance of trade = Export of visible items – Import of visible items

Capital Account
Capital account includes all those transactions between residents of a country and rest of the world which
leads to a change in the asset or liability status of the residents of a country or its government.
Components of capital account are as follows:

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 Foreign investments have two sub-components. They are Foreign Direct Investment (FDI) and
portfolio investment. The FDI refers to the purchase of asset by the rest of the world which allows
control over that asset, whereas portfolio investment refers to purchase of an asset by the rest of the
world without any control over that asset.
 Loans have two sub-components. They are commercial borrowings, borrowings as external assistance
and banking capital transactions.
o A commercial borrowing refers to borrowings of a country from the international money market at
market rate of interest.
o Borrowing as external assistance refers to borrowing by a country with considerations of
assistance. Their interest rate is low as compared to the prevailing rate in the open market.
o Banking capital transactions refers to transactions such as external financial assets and liabilities
of commercial banks and cooperative banks operate as an agent in foreign exchange.

In the capital account (BoP):

 Capital transactions are recorded as positive items because it is the flow of foreign exchange into the
country
 Capital transactions are recorded as negative items because it the flow of foreign exchange out of the
country
 FDI and portfolio investment are non-debt creating capital transactions where borrowings are debt
creating capital transactions

Autonomous and Accommodating Transactions

An autonomous item in balance of payments refers to international economic transactions which takes
place with profit motive.
When receipts of the country comes from autonomous transactions are less than the corresponding
payments to the rest of the world during the period of an accounting year. It shows net liabilities towards
rest of the world.
There are certain positive and negative impacts of deficit in balance of payment. When deficit occurs on
account of capital import which is required for advancing process of growth and development is the
positive impact of deficit in balance of payment. Negative impact is that it shows the Indian liabilities to
rest of the world and these liabilities damage the GDP by making payments to the rest of the world.

Meaning of Foreign Exchange Rate

Foreign exchange market is the market in which national

currencies are traded for one another. Foreign exchange rate
refers to the rate at which one unit of currency of a country is
exchanged for the number of units of currency of another
country.

Foreign exchange rate can be classified into 4 types:

 Nominal Exchange Rate (NER)
The nominal exchange rate is the price of per unit of
foreign currency in terms of domestic currency. It is the
bilateral nominal exchange rate because they are exchange rates for one currency against another. It
is nominal as they quote the exchange rate in money terms.

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 Nominal Effective Exchange Rate (NEER)

It is the exchange rate which does not account for changes in price level while measuring average
strength of one currency in relation to the other.
 Real Exchange Rate (RER)
The real exchange rate is the ratio of foreign to domestic prices measured in terms of one particular
currency.
 Real exchange rate = ePf / P
Where Pf and P are price levels of foreign nations and domestic respectively and e is the rupee price
of foreign exchange.
 Real Effective Exchange Rate (REER)
It is the exchange rate which accounts for changes in the price level across different countries of the
world.

Purchasing power parity refers to the ratio of purchasing power of the currencies of trading partners. It is
the ratio of price levels in different nations. Thus, exchange rate between the two nations is equal to the
ratio of the price levels in the two nations.
Rate of exchange = P1/P2
P1 – Price level in nation 1 and P2 – Price level in nation 2

Types of Exchange Rate

Fixed Exchange Rate

Fixed exchange rate is determined by the government or Central Bank of India. It ensures stability in the
international money market and encourages international trade. The most important concepts of fixed
exchange rate are:
 Gold Standard System of Exchange Rate: Gold standard system of exchange rate is the system
where gold is taken as the common unit of parity between currencies of different countries in
circulation. Each country was to define value of its currency in terms of gold. Accordingly value of one
currency in terms of the other currency was fixed considering gold value of each currency.
 The Bretton Woods System or Adjustable Peg System of Exchange Rate: The Bretton conference was
held in 1944 set up by the International Monetary Fund and the World Bank and re-established a
system of free exchange rates. This was different from the international gold standard system in the
choice of the asset in which national currencies would be convertible.

Devaluation is the decrease in the value of domestic currency corresponding to foreign currency as
planned by the government in a case where exchange rate is not determined by the demand and supply
forces but fixed by the government of varied nations.
Depreciation is the decrease in the value of domestic currency corresponding to foreign currency in a
case when exchange rate is determined by the forces of supply and demand in the international money
market. Both depreciation and devaluation will result in the value of domestic currency in terms of foreign
currency. However, the devaluation causes desired fall in the value of rupee which in turn boost the
exports. The depreciation causes undesired fall in the value of rupee where the import bill of the
government may become too high leading to a rise in fiscal deficit to unmanageable limits.

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Flexible Exchange Rate

Flexible rate of exchange is called free rate of exchange, as it is freely determined by demand and supply
forces in the international market.
Currency appreciation means a situation where domestic currency, the rupee, appreciates corresponding
to the foreign currency, the dollar. Fewer rupees are required to purchase a dollar like US dollar
exchanges for Rs. 50 instead of Rs. 55. Hence, the domestic currency indicates appreciation. Exports will
take a hit and the imports will tend to increase with the appreciation of currency.

Currency depreciation means a situation where domestic currency, the rupee, depreciates corresponding
to foreign currency, the dollar. More rupees are required to purchase a dollar like US dollar exchanges for
Rs. 55 instead of Rs. 50. Hence, the domestic currency indicates depreciation. Exports will tend to
increase and the imports will take a hit with the depreciation of currency.

 Determination of Flexible Rate of Exchange

Foreign exchange rate is determined by the demand and supply of foreign exchange. If the rate of foreign
exchange is said to be in equilibrium, the demand for some currency in terms of another currency equals
its supply.
The demand for foreign exchange is for the purpose of payments of international loans, gifts and grants to
rest of the world, investment in rest of the world, direct consumption abroad as well as imports from the
rest of the world and speculative trading in foreign exchange by our residents.
The supply of foreign exchange depends on the exports of the country to rest of the world, direct foreign
investment, direct consumption of goods and services by the non-residents in the domestic country,
speculative consumption by the non-residents in the domestic market and remittances by the non-
residents living in abroad.

Equilibrium rate of exchange occurs where supply of and demand for exchange is equal to each other. In
the figure given below, the SS curve is the supply of foreign currency which is positively related to the rate
of exchange. The DD curve is the demand for foreign currency which is negatively related to the
exchange rate. The point E is the equilibrium point where DD curve intersects the SS curve. It is an
equilibrium point and OR is the equilibrium rate of exchange. If the rate of exchange increases to OR 1,
then supply of foreign currency OV will exceed its demand OU by an amount equivalent to UV. Hence,
supply being more than demand, the rate of exchange will come down to OR. While the rate of exchange
falls to OR2, demand foreign currency OV will be more than its supply OU by UV. Demand being more
than supply, rate of exchange will again rise to OR. Therefore, rate of exchange will be determined at a
point where demand for and supply of foreign currency are equal.

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 Disequilibrium conditions – Impact of change in demand and supply

An increase in demand for foreign currency in India will cause a shift in the demand curve to the right.
With this consequence exchange rate rises from OR to OR1 i.e. more Indian rupee will be required to
buy the foreign currency. It implies that Indian rupee is depreciating. Currency depreciates only when
there is an increase in the domestic currency price of the foreign currency. The domestic currency is
relatively less valuable.
An increase in the supply of foreign currency will cause a shift in the supply curve to the right and the
exchange rate to fall. With this consequence, the price of foreign currency decreases from OR to OR1
and Indian rupee is appreciating. Currency appreciates only when there is a decrease in the domestic
currency price of the foreign currency. The domestic currency is relatively more valuable.

Managed Floating Rate System

Managed floating system is a system which allows adjustments in the exchange system as per the set of
rules and regulations which are officially declared in the foreign exchange market.

Determination of Income in an Open Economy

National Income Identity for an Open Economy

In a closed economy, there are no imports or exports. We have Y = C + I + G, where C is consumption, G
is government spending and I is domestic investment. Each item produced will be consumed by private
households or by government, or it will be classified as investment, to either produce future output or to be
inventorially used for consumption next period. We can also rearrange terms as Y - C - G = I, or S = I,
where S is total national saving. In a closed economy, total saving must equal investment.

In an open economy, goods and services can flow across national borders, so the GNP identity for open
economies shows how the national income which a country earns is divided between sales to domestic
residents and sales to foreign residents. The value of imports must be subtracted from the total domestic
spending, while the value of exports must be added to it. Total available supply in the economy consists of
domestic production (Y) and imports (M). Hence, Aggregate Supply (AS) = Y + M.
Aggregate demand (AD) consists of planned saving by the household (C), government (G), firms (I) and
the foreign country which purchases our exports (X). Hence, AD = C + I + G + X.
At equilibrium, AD = AS
C+I+G+X=Y+M
Y = C + I + G + X – M (or)
Y = C + I + G + NX
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where, NX is net exports.

A positive NX represents a trade surplus and negative NX represents a trade deficit. Exports and imports
depend on domestic income, foreign income and the real exchange rate.

Let C, I, G, X and M represents autonomous consumption, investment, government spending, exports and
imports respectively and where c represents MPC and m represents marginal propensity to import MPI.

C = C + cY 0<c<1
I = I
G =G
X =X
M = M + mY m>0

Increase in m caused by Re 1 increase is the marginal propensity to import (MPI) i.e. MPI = m.

At equilibrium,
Y = (C + cY) + I + G + X - M - mY
To solve, we will arrange as follows:
Y(1 - c + m) = C + I + G + X - M
Considering all the autonomous components together as A , we obtain
1
Y= A
(1 - c + m)

A change in autonomous expenditure causes Y to change by

1
times the change in expenditures.
(1 - c + m)
As we know, c is MPC and m is MPI, the open economy multiplier can be written as
1
1 - (MPC - MPI)
Because 1- MPC = MPS then 1 – (MPC – MPI) = (MPS + MPI). Thus, open economy multiplier can also
be written as
1
(MPS + MPI)
Because m or MPI is more than 1, we get a small multiplier in an open economy.

Equilibrium output and the trade balance

As we know, net exports (X-M) depend on income, foreign income and rate of exchange. An increase in
income Y increases import spending and leads to trade deficit. When there is an increase in foreign
income, other things remain constant and raise our exports which creates trade surplus and increases
aggregate income. The real depreciation would increase exports and decrease imports which increase
our net exports. Net exports are a decreasing function of domestic income. An increase in income leads
to an increase in imports and exports are unaffected leading to lower net exports. A goods market is in
equilibrium at the point where the supply of domestic output is equal to the demand for domestic output.
When the economy is more open, the smaller the effect on income, the larger the adverse effect on trade
balance. It implies that an increase in demand leads to an increase in imports more than the demand for
domestic goods. An increase in government spending, results in a large country’s trade deficit and a small
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increase in output and income, makes domestic demand expansion, an unattractive trade policy for the
country.

 Interdependent incomes- Increase in foreign demand

An increase in foreign income Y keeps prices and rate of exchange constant. The demand for domestic
goods is given by DD with the output level Y and equilibrium point is at E as shown in the below figure.
Assume trade is balanced, therefore an increase in foreign income and the net exports NX are equal to
zero. Difference between AD and DD is net exports and the trade is balanced at E where DD intersects
AD. Direct effect of an increase in income is to increase exports. Therefore, an increase in demand for
domestic goods shifts DD to DD1 and net export also shifts to NX1. Equilibrium point is at E1 with the
output level Y1. Through multiplier, an increase in foreign income leads to increase in domestic income.
Effect on trade balance: When imports increase, it does not offset the increase in exports and there is
trade surplus. On the other hand, a recession abroad would reduce domestic exports and it may cause a
trade deficit.
 Interdependent incomes- Change in prices
Assume exchange rate is fixed to consider the effects of change in prices. The decrease in price level of
domestic product would lead to an increase in domestic exports. Adding to aggregate demand, there
would be an increase in income and output. While an increase in price level of domestic product, it would
lead to decrease in domestic export, income and output. On the other hand, a price rise in abroad would
make the foreign product more expensive, and therefore net exports, domestic output and income will
increase.

 Interdependent incomes- Exchange rate changes

Changes in nominal exchange rates would change the real exchange rate and international relative
prices. When currency value depreciates, the price of foreign goods becomes costlier and the domestic
goods become cheaper. This increases the net exports, and therefore the aggregate demand increases.
International trade patterns take sufficient time to respond to any changes in the exchange rate.

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Trade Deficits, Savings and Investment

In a closed economy, saving and investment must always be equal, whereas it may be more or less in an
open economy. From the following equation, Y = C + I + G + NX, we can derive:
Y- C - G = I + NX or S = I + NX

Summing the private saving, Sp (Y - T - C) and government saving, Sg (T - G), we get

S = Y- C – G = (Y - T - C) + (T - G) = Sp + Sg
S = Sp + Sg = I + NX

Have to check the right side of the above equation, whether there has been a decrease in saving,
increase in investment or an increase in the budget. Trade deficits need not be alarming if the country
invests the borrowed funds, yielding a rate of growth higher than the interest rate.

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