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Open Economy Open Economy Open Economy Open Economy Open Economy
Macroeconomics Macroeconomics Macroeconomics Macroeconomics Macroeconomics
An open economy is one which interacts with other countries
through various channels. So far we had not considered
this aspect and just limited to a closed economy in which
there are no linkages with the rest of the world in order to
simplify our analysis and explain the basic macroeconomic
mechanisms. In reality, most modern economies are open.
There are three ways in which these linkages are
established.
1. Output Market: An economy can trade in goods and
services with other countries. This widens choice in the
sense that consumers and producers can choose between
domestic and foreign goods.
2. Financial Market: Most often an economy can buy
financial assets from other countries. This gives
investors the opportunity to choose between domestic
and foreign assets.
3. Labour Market: Firms can choose where to locate
production and workers to choose where to work. There
are various immigration laws which restrict the
movement of labour between countries.
Movement of goods has traditionally been seen as a
substitute for the movement of labour. We focus on the
first two linkages. Thus, an open economy is said to be one
that trades with other nations in goods and services and
most often, also in financial assets. Indians for instance,
can consume products which are produced around the world
and some of the products from India are exported to other
countries.
 Foreign trade, therefore, influences Indian aggregate
demand in two ways. First, when Indians buy foreign goods,
this spending escapes as a leakage from the circular flow
of income decreasing aggregate demand. Second, our exports
to foreigners enter as an injection into the circular flow,
increasing aggregate demand for goods produced within the
domestic economy.
When goods move across national borders, money must
be used for the transactions. At the international level there
is no single currency that is issued by a single bank. Foreign
Rationalised 2023-24
Page 2


Open Economy Open Economy Open Economy Open Economy Open Economy
Macroeconomics Macroeconomics Macroeconomics Macroeconomics Macroeconomics
An open economy is one which interacts with other countries
through various channels. So far we had not considered
this aspect and just limited to a closed economy in which
there are no linkages with the rest of the world in order to
simplify our analysis and explain the basic macroeconomic
mechanisms. In reality, most modern economies are open.
There are three ways in which these linkages are
established.
1. Output Market: An economy can trade in goods and
services with other countries. This widens choice in the
sense that consumers and producers can choose between
domestic and foreign goods.
2. Financial Market: Most often an economy can buy
financial assets from other countries. This gives
investors the opportunity to choose between domestic
and foreign assets.
3. Labour Market: Firms can choose where to locate
production and workers to choose where to work. There
are various immigration laws which restrict the
movement of labour between countries.
Movement of goods has traditionally been seen as a
substitute for the movement of labour. We focus on the
first two linkages. Thus, an open economy is said to be one
that trades with other nations in goods and services and
most often, also in financial assets. Indians for instance,
can consume products which are produced around the world
and some of the products from India are exported to other
countries.
 Foreign trade, therefore, influences Indian aggregate
demand in two ways. First, when Indians buy foreign goods,
this spending escapes as a leakage from the circular flow
of income decreasing aggregate demand. Second, our exports
to foreigners enter as an injection into the circular flow,
increasing aggregate demand for goods produced within the
domestic economy.
When goods move across national borders, money must
be used for the transactions. At the international level there
is no single currency that is issued by a single bank. Foreign
Rationalised 2023-24
86 86 86 86 86
Introductory Macroeconomics
economic agents will accept a national currency only if they are convinced that
the amount of goods they can buy with a certain amount of that currency will
not change frequently. In other words, the currency will maintain a stable
purchasing power. Without this confidence, a currency will not be used as an
international medium of exchange and unit of account since there is no
international authority with the power to force the use of a particular currency
in international transactions.
In the past, governments have tried to gain confidence of potential
users by announcing that the national currency will be freely convertible
at a fixed price into another asset. Also, the issuing authority will have
no control over the value of that asset into which the currency can be
converted. This other asset most often has been gold, or other national
currencies. There are two aspects of this commitment that has affected
its credibility — the ability to convert freely in unlimited amounts and the price
at which this conversion takes place. The international monetary system has
been set up to handle these issues and ensure stability in international
transactions.
With the increase in the volume of transactions, gold ceased to be the
asset into which national currencies could be converted (See Box 6.2).
Although some national currencies have international acceptability, what is
important in transactions between two countries is the currency in which
the trade occurs. For instance, if an Indian wants to buy a good made in
America, she would need dollars to complete the transaction. If the price of
the good is ten dollars, she would need to know how much it would cost her
in Indian rupees. That is, she will need to know the price of dollar in terms of
rupees. The price of one currency in terms of another currency is known as
the foreign exchange rate or simply the exchange rate. We will discuss
this in detail in section 6.2.
6.1 THE BALANCE OF PAYMENTS
The balance of payments (BoP) record the transactions in goods, services and assets
between residents of a country with the rest of the world for a specified time period
typically a year. There are two main accounts in the BoP — the current account
and the capital account
1
.
6.1.1 Current Account
Current Account is the record of trade in goods and services and transfer
payments. Figure 6.1 illustrates the components of Current Account.
Trade in goods includes exports and imports of goods. Trade in services
includes factor income and non-factor income transactions. Transfer
payments are the receipts which the residents of a country get for
‘free’, without having to provide any goods or services in return. They
consist of gifts, remittances and grants. They could be given by the
government or by private citizens living abroad.
1 
There is a new classification in which the balance of payments have been divided into three
accounts — the current account, the financial account and the capital account. This is as per the
new accounting standards specified by the International Monetary Fund (IMF) in the sixth edition of
the Balance of Payments and International Investment Position Manual (BPM6). India has also
made the change but the Reserve Bank of India continues to publish data accounting to the old
classification.
Rationalised 2023-24
Page 3


Open Economy Open Economy Open Economy Open Economy Open Economy
Macroeconomics Macroeconomics Macroeconomics Macroeconomics Macroeconomics
An open economy is one which interacts with other countries
through various channels. So far we had not considered
this aspect and just limited to a closed economy in which
there are no linkages with the rest of the world in order to
simplify our analysis and explain the basic macroeconomic
mechanisms. In reality, most modern economies are open.
There are three ways in which these linkages are
established.
1. Output Market: An economy can trade in goods and
services with other countries. This widens choice in the
sense that consumers and producers can choose between
domestic and foreign goods.
2. Financial Market: Most often an economy can buy
financial assets from other countries. This gives
investors the opportunity to choose between domestic
and foreign assets.
3. Labour Market: Firms can choose where to locate
production and workers to choose where to work. There
are various immigration laws which restrict the
movement of labour between countries.
Movement of goods has traditionally been seen as a
substitute for the movement of labour. We focus on the
first two linkages. Thus, an open economy is said to be one
that trades with other nations in goods and services and
most often, also in financial assets. Indians for instance,
can consume products which are produced around the world
and some of the products from India are exported to other
countries.
 Foreign trade, therefore, influences Indian aggregate
demand in two ways. First, when Indians buy foreign goods,
this spending escapes as a leakage from the circular flow
of income decreasing aggregate demand. Second, our exports
to foreigners enter as an injection into the circular flow,
increasing aggregate demand for goods produced within the
domestic economy.
When goods move across national borders, money must
be used for the transactions. At the international level there
is no single currency that is issued by a single bank. Foreign
Rationalised 2023-24
86 86 86 86 86
Introductory Macroeconomics
economic agents will accept a national currency only if they are convinced that
the amount of goods they can buy with a certain amount of that currency will
not change frequently. In other words, the currency will maintain a stable
purchasing power. Without this confidence, a currency will not be used as an
international medium of exchange and unit of account since there is no
international authority with the power to force the use of a particular currency
in international transactions.
In the past, governments have tried to gain confidence of potential
users by announcing that the national currency will be freely convertible
at a fixed price into another asset. Also, the issuing authority will have
no control over the value of that asset into which the currency can be
converted. This other asset most often has been gold, or other national
currencies. There are two aspects of this commitment that has affected
its credibility — the ability to convert freely in unlimited amounts and the price
at which this conversion takes place. The international monetary system has
been set up to handle these issues and ensure stability in international
transactions.
With the increase in the volume of transactions, gold ceased to be the
asset into which national currencies could be converted (See Box 6.2).
Although some national currencies have international acceptability, what is
important in transactions between two countries is the currency in which
the trade occurs. For instance, if an Indian wants to buy a good made in
America, she would need dollars to complete the transaction. If the price of
the good is ten dollars, she would need to know how much it would cost her
in Indian rupees. That is, she will need to know the price of dollar in terms of
rupees. The price of one currency in terms of another currency is known as
the foreign exchange rate or simply the exchange rate. We will discuss
this in detail in section 6.2.
6.1 THE BALANCE OF PAYMENTS
The balance of payments (BoP) record the transactions in goods, services and assets
between residents of a country with the rest of the world for a specified time period
typically a year. There are two main accounts in the BoP — the current account
and the capital account
1
.
6.1.1 Current Account
Current Account is the record of trade in goods and services and transfer
payments. Figure 6.1 illustrates the components of Current Account.
Trade in goods includes exports and imports of goods. Trade in services
includes factor income and non-factor income transactions. Transfer
payments are the receipts which the residents of a country get for
‘free’, without having to provide any goods or services in return. They
consist of gifts, remittances and grants. They could be given by the
government or by private citizens living abroad.
1 
There is a new classification in which the balance of payments have been divided into three
accounts — the current account, the financial account and the capital account. This is as per the
new accounting standards specified by the International Monetary Fund (IMF) in the sixth edition of
the Balance of Payments and International Investment Position Manual (BPM6). India has also
made the change but the Reserve Bank of India continues to publish data accounting to the old
classification.
Rationalised 2023-24
87 87 87 87 87
Open Economy
Macroeconomics
Buying foreign goods is expenditure from our country and it becomes the
income of that foreign country. Hence, the purchase of foreign goods or imports
decreases the domestic demand for goods and services in our country. Similarly,
selling of foreign goods or exports brings income to our country and adds to the
aggregate domestic demand for goods and services in our country.
Fig. 6.1: Components of Current Account
Balance on Current Account
Current Account is in balance when receipts on current account are
equal to the payments on the current account. A surplus current account
means that the nation is a lender to other countries and a deficit current
account means that the nation is a borrower from other countries.
Balance on Current Account has two components:
• ·Balance of Trade or Trade Balance
• ·Balance on Invisibles
Balance of Trade (BOT) is the difference between the value of exports
and value of imports of goods of a country in a given period of time.
Export of goods is entered as a credit item in BOT, whereas import of
goods is entered as a debit item in BOT. It is also known as Trade
Balance.
BOT is said to be in balance when exports of goods are equal to the
imports of goods. Surplus BOT or Trade surplus will arise if country
exports more goods than what it imports. Whereas, Deficit BOT or Trade
deficit will arise if a country imports more goods than what it exports.
Net Invisibles is the difference between the value of exports and value
Current Account Balanced Current  Current Account
      Surplus        Account Deficit
Receipts > Payments Receipts = Payments        Receipts < Payments
Rationalised 2023-24
Page 4


Open Economy Open Economy Open Economy Open Economy Open Economy
Macroeconomics Macroeconomics Macroeconomics Macroeconomics Macroeconomics
An open economy is one which interacts with other countries
through various channels. So far we had not considered
this aspect and just limited to a closed economy in which
there are no linkages with the rest of the world in order to
simplify our analysis and explain the basic macroeconomic
mechanisms. In reality, most modern economies are open.
There are three ways in which these linkages are
established.
1. Output Market: An economy can trade in goods and
services with other countries. This widens choice in the
sense that consumers and producers can choose between
domestic and foreign goods.
2. Financial Market: Most often an economy can buy
financial assets from other countries. This gives
investors the opportunity to choose between domestic
and foreign assets.
3. Labour Market: Firms can choose where to locate
production and workers to choose where to work. There
are various immigration laws which restrict the
movement of labour between countries.
Movement of goods has traditionally been seen as a
substitute for the movement of labour. We focus on the
first two linkages. Thus, an open economy is said to be one
that trades with other nations in goods and services and
most often, also in financial assets. Indians for instance,
can consume products which are produced around the world
and some of the products from India are exported to other
countries.
 Foreign trade, therefore, influences Indian aggregate
demand in two ways. First, when Indians buy foreign goods,
this spending escapes as a leakage from the circular flow
of income decreasing aggregate demand. Second, our exports
to foreigners enter as an injection into the circular flow,
increasing aggregate demand for goods produced within the
domestic economy.
When goods move across national borders, money must
be used for the transactions. At the international level there
is no single currency that is issued by a single bank. Foreign
Rationalised 2023-24
86 86 86 86 86
Introductory Macroeconomics
economic agents will accept a national currency only if they are convinced that
the amount of goods they can buy with a certain amount of that currency will
not change frequently. In other words, the currency will maintain a stable
purchasing power. Without this confidence, a currency will not be used as an
international medium of exchange and unit of account since there is no
international authority with the power to force the use of a particular currency
in international transactions.
In the past, governments have tried to gain confidence of potential
users by announcing that the national currency will be freely convertible
at a fixed price into another asset. Also, the issuing authority will have
no control over the value of that asset into which the currency can be
converted. This other asset most often has been gold, or other national
currencies. There are two aspects of this commitment that has affected
its credibility — the ability to convert freely in unlimited amounts and the price
at which this conversion takes place. The international monetary system has
been set up to handle these issues and ensure stability in international
transactions.
With the increase in the volume of transactions, gold ceased to be the
asset into which national currencies could be converted (See Box 6.2).
Although some national currencies have international acceptability, what is
important in transactions between two countries is the currency in which
the trade occurs. For instance, if an Indian wants to buy a good made in
America, she would need dollars to complete the transaction. If the price of
the good is ten dollars, she would need to know how much it would cost her
in Indian rupees. That is, she will need to know the price of dollar in terms of
rupees. The price of one currency in terms of another currency is known as
the foreign exchange rate or simply the exchange rate. We will discuss
this in detail in section 6.2.
6.1 THE BALANCE OF PAYMENTS
The balance of payments (BoP) record the transactions in goods, services and assets
between residents of a country with the rest of the world for a specified time period
typically a year. There are two main accounts in the BoP — the current account
and the capital account
1
.
6.1.1 Current Account
Current Account is the record of trade in goods and services and transfer
payments. Figure 6.1 illustrates the components of Current Account.
Trade in goods includes exports and imports of goods. Trade in services
includes factor income and non-factor income transactions. Transfer
payments are the receipts which the residents of a country get for
‘free’, without having to provide any goods or services in return. They
consist of gifts, remittances and grants. They could be given by the
government or by private citizens living abroad.
1 
There is a new classification in which the balance of payments have been divided into three
accounts — the current account, the financial account and the capital account. This is as per the
new accounting standards specified by the International Monetary Fund (IMF) in the sixth edition of
the Balance of Payments and International Investment Position Manual (BPM6). India has also
made the change but the Reserve Bank of India continues to publish data accounting to the old
classification.
Rationalised 2023-24
87 87 87 87 87
Open Economy
Macroeconomics
Buying foreign goods is expenditure from our country and it becomes the
income of that foreign country. Hence, the purchase of foreign goods or imports
decreases the domestic demand for goods and services in our country. Similarly,
selling of foreign goods or exports brings income to our country and adds to the
aggregate domestic demand for goods and services in our country.
Fig. 6.1: Components of Current Account
Balance on Current Account
Current Account is in balance when receipts on current account are
equal to the payments on the current account. A surplus current account
means that the nation is a lender to other countries and a deficit current
account means that the nation is a borrower from other countries.
Balance on Current Account has two components:
• ·Balance of Trade or Trade Balance
• ·Balance on Invisibles
Balance of Trade (BOT) is the difference between the value of exports
and value of imports of goods of a country in a given period of time.
Export of goods is entered as a credit item in BOT, whereas import of
goods is entered as a debit item in BOT. It is also known as Trade
Balance.
BOT is said to be in balance when exports of goods are equal to the
imports of goods. Surplus BOT or Trade surplus will arise if country
exports more goods than what it imports. Whereas, Deficit BOT or Trade
deficit will arise if a country imports more goods than what it exports.
Net Invisibles is the difference between the value of exports and value
Current Account Balanced Current  Current Account
      Surplus        Account Deficit
Receipts > Payments Receipts = Payments        Receipts < Payments
Rationalised 2023-24
88 88 88 88 88
Introductory Macroeconomics
of imports of invisibles of a country in a given period of time. Invisibles include
services, transfers and flows of income that take place between different countries.
Services trade includes both factor and non-factor income. Factor income includes
net international earnings on factors of production (like labour, land and capital).
Non-factor income is net sale of service products like shipping, banking, tourism,
software services, etc.
6.1.2  Capital Account
Capital Account records all international transactions of assets. An asset is any
one of the forms in which wealth can be held, for example: money, stocks, bonds,
Government debt, etc. Purchase of assets is a debit item on the capital account.
If an Indian buys a UK Car Company, it enters capital account transactions as
a debit item (as foreign exchange is flowing out of India). On the other hand, sale
of assets like sale of share of an Indian company to a Chinese customer is a
credit item on the capital account. Fig. 6.2 classifies the items which are a part
of capital account transactions. These items are Foreign Direct Investments (FDIs),
Foreign Institutional Investments (FIIs), external borrowings and assistance.
Fig. 6.2: Components of Capital Account
Balance on Capital Account
Capital account is in balance when capital inflows (like receipt of loans from
abroad, sale of assets or shares in foreign companies) are equal to capital outflows
(like repayment of loans, purchase of assets or shares in foreign countries).
Surplus in capital account arises when capital inflows are greater than capital
outflows, whereas deficit in capital account arises when capital inflows are lesser
than capital outflows.
6.1.3  Balance of Payments Surplus and Deficit
The essence of international payments is that just like an individual who spends
more than her income must finance the difference by selling assets or by
borrowing, a country that has a deficit in its current account (spending more
Rationalised 2023-24
Page 5


Open Economy Open Economy Open Economy Open Economy Open Economy
Macroeconomics Macroeconomics Macroeconomics Macroeconomics Macroeconomics
An open economy is one which interacts with other countries
through various channels. So far we had not considered
this aspect and just limited to a closed economy in which
there are no linkages with the rest of the world in order to
simplify our analysis and explain the basic macroeconomic
mechanisms. In reality, most modern economies are open.
There are three ways in which these linkages are
established.
1. Output Market: An economy can trade in goods and
services with other countries. This widens choice in the
sense that consumers and producers can choose between
domestic and foreign goods.
2. Financial Market: Most often an economy can buy
financial assets from other countries. This gives
investors the opportunity to choose between domestic
and foreign assets.
3. Labour Market: Firms can choose where to locate
production and workers to choose where to work. There
are various immigration laws which restrict the
movement of labour between countries.
Movement of goods has traditionally been seen as a
substitute for the movement of labour. We focus on the
first two linkages. Thus, an open economy is said to be one
that trades with other nations in goods and services and
most often, also in financial assets. Indians for instance,
can consume products which are produced around the world
and some of the products from India are exported to other
countries.
 Foreign trade, therefore, influences Indian aggregate
demand in two ways. First, when Indians buy foreign goods,
this spending escapes as a leakage from the circular flow
of income decreasing aggregate demand. Second, our exports
to foreigners enter as an injection into the circular flow,
increasing aggregate demand for goods produced within the
domestic economy.
When goods move across national borders, money must
be used for the transactions. At the international level there
is no single currency that is issued by a single bank. Foreign
Rationalised 2023-24
86 86 86 86 86
Introductory Macroeconomics
economic agents will accept a national currency only if they are convinced that
the amount of goods they can buy with a certain amount of that currency will
not change frequently. In other words, the currency will maintain a stable
purchasing power. Without this confidence, a currency will not be used as an
international medium of exchange and unit of account since there is no
international authority with the power to force the use of a particular currency
in international transactions.
In the past, governments have tried to gain confidence of potential
users by announcing that the national currency will be freely convertible
at a fixed price into another asset. Also, the issuing authority will have
no control over the value of that asset into which the currency can be
converted. This other asset most often has been gold, or other national
currencies. There are two aspects of this commitment that has affected
its credibility — the ability to convert freely in unlimited amounts and the price
at which this conversion takes place. The international monetary system has
been set up to handle these issues and ensure stability in international
transactions.
With the increase in the volume of transactions, gold ceased to be the
asset into which national currencies could be converted (See Box 6.2).
Although some national currencies have international acceptability, what is
important in transactions between two countries is the currency in which
the trade occurs. For instance, if an Indian wants to buy a good made in
America, she would need dollars to complete the transaction. If the price of
the good is ten dollars, she would need to know how much it would cost her
in Indian rupees. That is, she will need to know the price of dollar in terms of
rupees. The price of one currency in terms of another currency is known as
the foreign exchange rate or simply the exchange rate. We will discuss
this in detail in section 6.2.
6.1 THE BALANCE OF PAYMENTS
The balance of payments (BoP) record the transactions in goods, services and assets
between residents of a country with the rest of the world for a specified time period
typically a year. There are two main accounts in the BoP — the current account
and the capital account
1
.
6.1.1 Current Account
Current Account is the record of trade in goods and services and transfer
payments. Figure 6.1 illustrates the components of Current Account.
Trade in goods includes exports and imports of goods. Trade in services
includes factor income and non-factor income transactions. Transfer
payments are the receipts which the residents of a country get for
‘free’, without having to provide any goods or services in return. They
consist of gifts, remittances and grants. They could be given by the
government or by private citizens living abroad.
1 
There is a new classification in which the balance of payments have been divided into three
accounts — the current account, the financial account and the capital account. This is as per the
new accounting standards specified by the International Monetary Fund (IMF) in the sixth edition of
the Balance of Payments and International Investment Position Manual (BPM6). India has also
made the change but the Reserve Bank of India continues to publish data accounting to the old
classification.
Rationalised 2023-24
87 87 87 87 87
Open Economy
Macroeconomics
Buying foreign goods is expenditure from our country and it becomes the
income of that foreign country. Hence, the purchase of foreign goods or imports
decreases the domestic demand for goods and services in our country. Similarly,
selling of foreign goods or exports brings income to our country and adds to the
aggregate domestic demand for goods and services in our country.
Fig. 6.1: Components of Current Account
Balance on Current Account
Current Account is in balance when receipts on current account are
equal to the payments on the current account. A surplus current account
means that the nation is a lender to other countries and a deficit current
account means that the nation is a borrower from other countries.
Balance on Current Account has two components:
• ·Balance of Trade or Trade Balance
• ·Balance on Invisibles
Balance of Trade (BOT) is the difference between the value of exports
and value of imports of goods of a country in a given period of time.
Export of goods is entered as a credit item in BOT, whereas import of
goods is entered as a debit item in BOT. It is also known as Trade
Balance.
BOT is said to be in balance when exports of goods are equal to the
imports of goods. Surplus BOT or Trade surplus will arise if country
exports more goods than what it imports. Whereas, Deficit BOT or Trade
deficit will arise if a country imports more goods than what it exports.
Net Invisibles is the difference between the value of exports and value
Current Account Balanced Current  Current Account
      Surplus        Account Deficit
Receipts > Payments Receipts = Payments        Receipts < Payments
Rationalised 2023-24
88 88 88 88 88
Introductory Macroeconomics
of imports of invisibles of a country in a given period of time. Invisibles include
services, transfers and flows of income that take place between different countries.
Services trade includes both factor and non-factor income. Factor income includes
net international earnings on factors of production (like labour, land and capital).
Non-factor income is net sale of service products like shipping, banking, tourism,
software services, etc.
6.1.2  Capital Account
Capital Account records all international transactions of assets. An asset is any
one of the forms in which wealth can be held, for example: money, stocks, bonds,
Government debt, etc. Purchase of assets is a debit item on the capital account.
If an Indian buys a UK Car Company, it enters capital account transactions as
a debit item (as foreign exchange is flowing out of India). On the other hand, sale
of assets like sale of share of an Indian company to a Chinese customer is a
credit item on the capital account. Fig. 6.2 classifies the items which are a part
of capital account transactions. These items are Foreign Direct Investments (FDIs),
Foreign Institutional Investments (FIIs), external borrowings and assistance.
Fig. 6.2: Components of Capital Account
Balance on Capital Account
Capital account is in balance when capital inflows (like receipt of loans from
abroad, sale of assets or shares in foreign companies) are equal to capital outflows
(like repayment of loans, purchase of assets or shares in foreign countries).
Surplus in capital account arises when capital inflows are greater than capital
outflows, whereas deficit in capital account arises when capital inflows are lesser
than capital outflows.
6.1.3  Balance of Payments Surplus and Deficit
The essence of international payments is that just like an individual who spends
more than her income must finance the difference by selling assets or by
borrowing, a country that has a deficit in its current account (spending more
Rationalised 2023-24
89 89 89 89 89
Open Economy
Macroeconomics
than it receives from sales to the rest of the world) must finance it by selling
assets or by borrowing abroad. Thus, any current account deficit must be
financed by a capital account surplus, that is, a net capital inflow.
Current account + Capital account 0 =
In this case, in which a country is said to be in balance of payments
equilibrium, the current account deficit is financed entirely by
international lending without any reserve movements.
Alternatively, the country could use its reserves of foreign exchange
in order to balance any deficit in its balance of payments. The reserve
bank sells foreign exchange when there is a deficit. This is called official
reserve sale. The decrease (increase) in official reserves is called the
overall balance of payments deficit (surplus). The basic premise is that
the monetary authorities are the ultimate financiers of any deficit in
the balance of payments (or the recipients of any surplus).
We note that official reserve transactions are more relevant under a
regime of fixed exchange rates than when exchange rates are floating.
(See sub heading ‘Fixed Exchange Rates’ under section 6.2.2)
Autonomous and Accommodating Transactions
International economic transactions are called autonomous when
transactions are made due to some reason other than to bridge the gap
in the balance of payments, that is, when they are independent of the
state of BoP. One reason could be to earn profit. These items are called
‘above the line’ items in the BoP. The balance of payments is said to be
in surplus (deficit) if autonomous receipts are greater (less) than
autonomous payments.
Accommodating transactions (termed ‘below the line’ items), on the
other hand, are determined by the gap in the balance of payments, that
is, whether there is a deficit or surplus in the balance of payments. In
other words, they are determined by the net consequences of the
autonomous transactions. Since the official reserve transactions are
made to bridge the gap in the BoP, they are seen as the accommodating
item in the BoP (all others being autonomous).
Errors and Omissions
It is difficult to record all international transactions accurately. Thus,
we have a third element of BoP (apart from the current and capital
accounts) called errors and omissions which reflects this.
Table 6.1 provides a sample of Balance of Payments for India.
Note in this table, there is a trade deficit and current account deficit but a capital
account surplus. As a result, BOP is in balance.
BoP Deficit Balanced BoP BoP Surplus
Overall Balance < 0 Overall Balance = 0 Overall Balance > 0
Reserve Change > 0 Reserve Change = 0 Reserve Change < 0
Rationalised 2023-24
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FAQs on NCERT Textbook: Open Economy Macroeconomics - Indian Economy for UPSC CSE

1. What is an open economy in macroeconomics?
Ans. An open economy in macroeconomics refers to a country that engages in international trade and has economic interactions with other nations. It allows for the flow of goods, services, capital, and labor across its borders. Unlike a closed economy, an open economy considers foreign trade and influences from global markets in its economic policies and analysis.
2. How does international trade affect the open economy?
Ans. International trade plays a significant role in an open economy. It allows for the exchange of goods and services between countries, leading to specialization and efficiency gains. Trade can enhance a country's economic growth, increase its consumption options, and provide access to resources that may be scarce domestically. Additionally, international trade can influence the balance of payments, exchange rates, and overall economic stability.
3. What is the balance of payments in an open economy?
Ans. The balance of payments refers to the record of all financial transactions between a country and the rest of the world during a specific period. It includes the current account, capital account, and financial account. The current account records transactions related to trade in goods and services, income from investments, and unilateral transfers. The capital account records capital transfers, while the financial account tracks financial investments and assets.
4. How does exchange rate volatility affect an open economy?
Ans. Exchange rate volatility can have both positive and negative effects on an open economy. On one hand, exchange rate fluctuations can impact the competitiveness of a country's exports and imports. A depreciating domestic currency can make a country's exports cheaper and boost its export industries. Conversely, an appreciating currency can make imports cheaper but may harm export competitiveness. Exchange rate volatility can also affect foreign investments, as it influences the relative returns and risks associated with investing in a particular country.
5. What are the policy instruments used to manage an open economy?
Ans. Governments use various policy instruments to manage an open economy. These include fiscal policy, monetary policy, and exchange rate policy. Fiscal policy involves the use of government spending, taxation, and borrowing to influence aggregate demand and stabilize the economy. Monetary policy involves adjusting interest rates, money supply, and credit conditions to control inflation, promote economic growth, and manage exchange rates. Exchange rate policy refers to interventions or policies adopted by the government or central bank to influence the value of the domestic currency in relation to other currencies.
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