NCERT Textbook - Open Economy Macroeconomics Commerce Notes | EduRev

Economics Class 12

Created by: Lakshya Ias

Commerce : NCERT Textbook - Open Economy Macroeconomics Commerce Notes | EduRev

 Page 1


Chapter 6
Open Economy Open Economy Open Economy Open Economy Open Economy
Macroeconomics Macroeconomics Macroeconomics Macroeconomics Macroeconomics
We have so far assumed that the economy was closed—that it did
not interact with the rest of the world. This was done to keep the
model simple and explain the basic macroeconomic mechanisms.
In reality, most modern economies are open. Interaction with other
economies of the world widens choice in three broad ways
(i) Consumers and firms have the opportunity to choose between
domestic and foreign goods. This is the product market linkage
which occurs through international trade.
(ii) Investors have the opportunity to choose between domestic and
foreign assets. This constitutes the financial market linkage.
(iii) Firms can choose where to locate production and workers to
choose where to work. This is the factor market linkage. Labour
market linkages have been relatively less due to various
restrictions on the movement of people through immigration
laws. Movement of goods has traditionally been seen as a
substitute for the movement of labour . We focus here on the first
two linkages.
An open economy is one that trades with other nations in
goods and services and, most often, also in financial assets. Indians,
for instance, enjoy using products produced around the world
and some of our production is exported to foreign 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
domestically produced goods. Total foreign trade (exports +
imports) as a proportion of GDP is a common measure of the degree
of openness of an economy. In 2013-14, this was 44.1 per cent
for the Indian Economy.  There are several countries whose foreign
trade proportions are above 50 per cent of GDP.
Now, when goods move across national borders, money must
move in the opposite direction. At the international level, there is no
single currency that is issued by a central authority. Foreign economic
agents will accept a national currency only if they are convinced that
the currency will maintain a stable purchasing power. Without this
confidence, a currency will not be used as an international medium
2015-16(21/01/2015)
Page 2


Chapter 6
Open Economy Open Economy Open Economy Open Economy Open Economy
Macroeconomics Macroeconomics Macroeconomics Macroeconomics Macroeconomics
We have so far assumed that the economy was closed—that it did
not interact with the rest of the world. This was done to keep the
model simple and explain the basic macroeconomic mechanisms.
In reality, most modern economies are open. Interaction with other
economies of the world widens choice in three broad ways
(i) Consumers and firms have the opportunity to choose between
domestic and foreign goods. This is the product market linkage
which occurs through international trade.
(ii) Investors have the opportunity to choose between domestic and
foreign assets. This constitutes the financial market linkage.
(iii) Firms can choose where to locate production and workers to
choose where to work. This is the factor market linkage. Labour
market linkages have been relatively less due to various
restrictions on the movement of people through immigration
laws. Movement of goods has traditionally been seen as a
substitute for the movement of labour . We focus here on the first
two linkages.
An open economy is one that trades with other nations in
goods and services and, most often, also in financial assets. Indians,
for instance, enjoy using products produced around the world
and some of our production is exported to foreign 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
domestically produced goods. Total foreign trade (exports +
imports) as a proportion of GDP is a common measure of the degree
of openness of an economy. In 2013-14, this was 44.1 per cent
for the Indian Economy.  There are several countries whose foreign
trade proportions are above 50 per cent of GDP.
Now, when goods move across national borders, money must
move in the opposite direction. At the international level, there is no
single currency that is issued by a central authority. Foreign economic
agents will accept a national currency only if they are convinced that
the currency will maintain a stable purchasing power. Without this
confidence, a currency will not be used as an international medium
2015-16(21/01/2015)
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.
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,
over whose value the issuing authority has no control. 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 conversion takes place. The international monetary system
has been set up to handle these issues and ensure stability in international
transactions. A nation’s commitment regarding the above two issues will affect its
trade and financial interactions with the rest of the world.
We begin section 6.1 with the accounting of international trade and financial
flows. The next section examines the determination of price at which national currencies
are exchanged for each other. In section 6.3, the closed economy income-expenditure
model is amended to include international effects. Section 6.4 deals with the linkage
between the trade deficit, budget deficit and the savings - investment gap briefly.
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. Table 6.1 gives the balance of payments summary
for the Indian Economy for the year 2012-13. There are two main accounts in
the BoP – the current account and the capital account.
The current account records exports and imports in goods and services and
transfer payments. The first two items in Table 6.1 record exports and imports of
goods. The third item gives the trade balance which is obtained by subtracting
imports of goods from the exports of goods. When exports exceed imports, there is
a trade surplus and when imports exceed exports there is a trade deficit. In
2012-13, imports exceeded exports leading to a huge trade deficit in India of
US $ 195.6 billion. Trade in services denoted as invisible trade (because they are
not seen to cross national borders) includes both factor income (net income from
compensation of employees and net investment income, the latter equals, the interest,
profits and dividends on our assets abroad minus the income foreigners earn on
assets they own in India) and net non-factor income (shipping, banking, insurance,
tourism, software services, etc.). Transfer payments are receipts which the residents
of a country receive ‘for free’, without having to make any present or future payments
in return. They consist of remittances, gifts and grants. They could be official or
private. The balance of exports and imports of goods is referred to as the trade
balance. Adding trade in services and net transfers to the trade balance, we get the
current account balance shown in item 5 of Table 6.1. This figure means that
transactions from the current account component caused –88.2 billion more dollars
to flow out as payment than the receipts that flowed in. This is referred to as a
current account deficit for 2012-13 works out to 4.7 per cent of GDP. If this
figure had been a positive number, there would have been a current account
surplus. The capital account records all international purchases and sales of assets
such as money, stocks, bonds, etc. We note that any transaction resulting in a
payment to foreigners is entered as a debit and is given a negative sign. Any
transaction resulting in a receipt from foreigners is entered as a credit and is given
a positive sign.
EXAMPLE  6.1
Can a country have a trade deficit and a current account surplus simultaneously?
77 77 77 77 77
Open Economy
Macroeconomics
2015-16(21/01/2015)
Page 3


Chapter 6
Open Economy Open Economy Open Economy Open Economy Open Economy
Macroeconomics Macroeconomics Macroeconomics Macroeconomics Macroeconomics
We have so far assumed that the economy was closed—that it did
not interact with the rest of the world. This was done to keep the
model simple and explain the basic macroeconomic mechanisms.
In reality, most modern economies are open. Interaction with other
economies of the world widens choice in three broad ways
(i) Consumers and firms have the opportunity to choose between
domestic and foreign goods. This is the product market linkage
which occurs through international trade.
(ii) Investors have the opportunity to choose between domestic and
foreign assets. This constitutes the financial market linkage.
(iii) Firms can choose where to locate production and workers to
choose where to work. This is the factor market linkage. Labour
market linkages have been relatively less due to various
restrictions on the movement of people through immigration
laws. Movement of goods has traditionally been seen as a
substitute for the movement of labour . We focus here on the first
two linkages.
An open economy is one that trades with other nations in
goods and services and, most often, also in financial assets. Indians,
for instance, enjoy using products produced around the world
and some of our production is exported to foreign 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
domestically produced goods. Total foreign trade (exports +
imports) as a proportion of GDP is a common measure of the degree
of openness of an economy. In 2013-14, this was 44.1 per cent
for the Indian Economy.  There are several countries whose foreign
trade proportions are above 50 per cent of GDP.
Now, when goods move across national borders, money must
move in the opposite direction. At the international level, there is no
single currency that is issued by a central authority. Foreign economic
agents will accept a national currency only if they are convinced that
the currency will maintain a stable purchasing power. Without this
confidence, a currency will not be used as an international medium
2015-16(21/01/2015)
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.
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,
over whose value the issuing authority has no control. 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 conversion takes place. The international monetary system
has been set up to handle these issues and ensure stability in international
transactions. A nation’s commitment regarding the above two issues will affect its
trade and financial interactions with the rest of the world.
We begin section 6.1 with the accounting of international trade and financial
flows. The next section examines the determination of price at which national currencies
are exchanged for each other. In section 6.3, the closed economy income-expenditure
model is amended to include international effects. Section 6.4 deals with the linkage
between the trade deficit, budget deficit and the savings - investment gap briefly.
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. Table 6.1 gives the balance of payments summary
for the Indian Economy for the year 2012-13. There are two main accounts in
the BoP – the current account and the capital account.
The current account records exports and imports in goods and services and
transfer payments. The first two items in Table 6.1 record exports and imports of
goods. The third item gives the trade balance which is obtained by subtracting
imports of goods from the exports of goods. When exports exceed imports, there is
a trade surplus and when imports exceed exports there is a trade deficit. In
2012-13, imports exceeded exports leading to a huge trade deficit in India of
US $ 195.6 billion. Trade in services denoted as invisible trade (because they are
not seen to cross national borders) includes both factor income (net income from
compensation of employees and net investment income, the latter equals, the interest,
profits and dividends on our assets abroad minus the income foreigners earn on
assets they own in India) and net non-factor income (shipping, banking, insurance,
tourism, software services, etc.). Transfer payments are receipts which the residents
of a country receive ‘for free’, without having to make any present or future payments
in return. They consist of remittances, gifts and grants. They could be official or
private. The balance of exports and imports of goods is referred to as the trade
balance. Adding trade in services and net transfers to the trade balance, we get the
current account balance shown in item 5 of Table 6.1. This figure means that
transactions from the current account component caused –88.2 billion more dollars
to flow out as payment than the receipts that flowed in. This is referred to as a
current account deficit for 2012-13 works out to 4.7 per cent of GDP. If this
figure had been a positive number, there would have been a current account
surplus. The capital account records all international purchases and sales of assets
such as money, stocks, bonds, etc. We note that any transaction resulting in a
payment to foreigners is entered as a debit and is given a negative sign. Any
transaction resulting in a receipt from foreigners is entered as a credit and is given
a positive sign.
EXAMPLE  6.1
Can a country have a trade deficit and a current account surplus simultaneously?
77 77 77 77 77
Open Economy
Macroeconomics
2015-16(21/01/2015)
78 78 78 78 78
Introductory Macroeconomics
Yes, in India, although trade deficit is a recurrent feature every year, for three
consecutive years from 2001-02, 2002-03 to 2003-04, there was a surplus on the
current account, to the tune of 0.7, 1.3 and 2.3 per cents of GDP respectively. This
is because that earnings from services and private transfers outweighed the trade
deficit.
6.1.1 BoP 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
abroad 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 is of
necessity financed by a net capital inflow.
Alternatively, the country could engage in official reserve transactions,
running down its reserves of foreign exchange, in the case of a deficit by selling
foreign currency in the foreign exchange market. 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). The balance of
payments deficit or surplus is obtained after adding the current and capital
account balances. In 2012-13, there was a balance of payments surplus of US$
3.8 billion in item 14 of Table 6.1. This was the amount of addition to official
reserves. A country is said to be in balance of payments equilibrium when the
sum of its current account and its non-reserve capital account equals zero, so
that the current account balance is financed entirely by international lending
without reserve movements. We note that the official reserve transactions are
more relevant under a regime of pegged exchange rates than when exchange
rates are floating. (See section 6.2.3)
Autonomous and Accommodating Transactions: International economic
transactions are called autonomous when transactions are made independently
of the state of the BoP (for instance due to profit motive). 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 net consequences of the autonomous items, that is, whether
the BoP is in surplus or deficit. The official reserve transactions are seen as the
accommodating item in the BoP (all others being autonomous).
Errors and Omissions constitute the third element in the BoP (apart from
the current and capital accounts) which is the ‘balancing item’ reflecting our
inability to record all international transactions accurately.
6.2 THE FOREIGN EXCHANGE MARKET
Having considered accounting of
international transactions on the
whole, we will now take up a single
transaction. Let us assume that an
Indian resident wants to visit London
on a vacation (an import of tourist
services). She will have to pay in
pounds for her stay there. She will need
to know where to obtain the pounds
Your currency in exchange for the dollar?
Should exchange rates between two currencies
continue like this? Discuss.
2015-16(21/01/2015)
Page 4


Chapter 6
Open Economy Open Economy Open Economy Open Economy Open Economy
Macroeconomics Macroeconomics Macroeconomics Macroeconomics Macroeconomics
We have so far assumed that the economy was closed—that it did
not interact with the rest of the world. This was done to keep the
model simple and explain the basic macroeconomic mechanisms.
In reality, most modern economies are open. Interaction with other
economies of the world widens choice in three broad ways
(i) Consumers and firms have the opportunity to choose between
domestic and foreign goods. This is the product market linkage
which occurs through international trade.
(ii) Investors have the opportunity to choose between domestic and
foreign assets. This constitutes the financial market linkage.
(iii) Firms can choose where to locate production and workers to
choose where to work. This is the factor market linkage. Labour
market linkages have been relatively less due to various
restrictions on the movement of people through immigration
laws. Movement of goods has traditionally been seen as a
substitute for the movement of labour . We focus here on the first
two linkages.
An open economy is one that trades with other nations in
goods and services and, most often, also in financial assets. Indians,
for instance, enjoy using products produced around the world
and some of our production is exported to foreign 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
domestically produced goods. Total foreign trade (exports +
imports) as a proportion of GDP is a common measure of the degree
of openness of an economy. In 2013-14, this was 44.1 per cent
for the Indian Economy.  There are several countries whose foreign
trade proportions are above 50 per cent of GDP.
Now, when goods move across national borders, money must
move in the opposite direction. At the international level, there is no
single currency that is issued by a central authority. Foreign economic
agents will accept a national currency only if they are convinced that
the currency will maintain a stable purchasing power. Without this
confidence, a currency will not be used as an international medium
2015-16(21/01/2015)
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.
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,
over whose value the issuing authority has no control. 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 conversion takes place. The international monetary system
has been set up to handle these issues and ensure stability in international
transactions. A nation’s commitment regarding the above two issues will affect its
trade and financial interactions with the rest of the world.
We begin section 6.1 with the accounting of international trade and financial
flows. The next section examines the determination of price at which national currencies
are exchanged for each other. In section 6.3, the closed economy income-expenditure
model is amended to include international effects. Section 6.4 deals with the linkage
between the trade deficit, budget deficit and the savings - investment gap briefly.
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. Table 6.1 gives the balance of payments summary
for the Indian Economy for the year 2012-13. There are two main accounts in
the BoP – the current account and the capital account.
The current account records exports and imports in goods and services and
transfer payments. The first two items in Table 6.1 record exports and imports of
goods. The third item gives the trade balance which is obtained by subtracting
imports of goods from the exports of goods. When exports exceed imports, there is
a trade surplus and when imports exceed exports there is a trade deficit. In
2012-13, imports exceeded exports leading to a huge trade deficit in India of
US $ 195.6 billion. Trade in services denoted as invisible trade (because they are
not seen to cross national borders) includes both factor income (net income from
compensation of employees and net investment income, the latter equals, the interest,
profits and dividends on our assets abroad minus the income foreigners earn on
assets they own in India) and net non-factor income (shipping, banking, insurance,
tourism, software services, etc.). Transfer payments are receipts which the residents
of a country receive ‘for free’, without having to make any present or future payments
in return. They consist of remittances, gifts and grants. They could be official or
private. The balance of exports and imports of goods is referred to as the trade
balance. Adding trade in services and net transfers to the trade balance, we get the
current account balance shown in item 5 of Table 6.1. This figure means that
transactions from the current account component caused –88.2 billion more dollars
to flow out as payment than the receipts that flowed in. This is referred to as a
current account deficit for 2012-13 works out to 4.7 per cent of GDP. If this
figure had been a positive number, there would have been a current account
surplus. The capital account records all international purchases and sales of assets
such as money, stocks, bonds, etc. We note that any transaction resulting in a
payment to foreigners is entered as a debit and is given a negative sign. Any
transaction resulting in a receipt from foreigners is entered as a credit and is given
a positive sign.
EXAMPLE  6.1
Can a country have a trade deficit and a current account surplus simultaneously?
77 77 77 77 77
Open Economy
Macroeconomics
2015-16(21/01/2015)
78 78 78 78 78
Introductory Macroeconomics
Yes, in India, although trade deficit is a recurrent feature every year, for three
consecutive years from 2001-02, 2002-03 to 2003-04, there was a surplus on the
current account, to the tune of 0.7, 1.3 and 2.3 per cents of GDP respectively. This
is because that earnings from services and private transfers outweighed the trade
deficit.
6.1.1 BoP 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
abroad 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 is of
necessity financed by a net capital inflow.
Alternatively, the country could engage in official reserve transactions,
running down its reserves of foreign exchange, in the case of a deficit by selling
foreign currency in the foreign exchange market. 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). The balance of
payments deficit or surplus is obtained after adding the current and capital
account balances. In 2012-13, there was a balance of payments surplus of US$
3.8 billion in item 14 of Table 6.1. This was the amount of addition to official
reserves. A country is said to be in balance of payments equilibrium when the
sum of its current account and its non-reserve capital account equals zero, so
that the current account balance is financed entirely by international lending
without reserve movements. We note that the official reserve transactions are
more relevant under a regime of pegged exchange rates than when exchange
rates are floating. (See section 6.2.3)
Autonomous and Accommodating Transactions: International economic
transactions are called autonomous when transactions are made independently
of the state of the BoP (for instance due to profit motive). 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 net consequences of the autonomous items, that is, whether
the BoP is in surplus or deficit. The official reserve transactions are seen as the
accommodating item in the BoP (all others being autonomous).
Errors and Omissions constitute the third element in the BoP (apart from
the current and capital accounts) which is the ‘balancing item’ reflecting our
inability to record all international transactions accurately.
6.2 THE FOREIGN EXCHANGE MARKET
Having considered accounting of
international transactions on the
whole, we will now take up a single
transaction. Let us assume that an
Indian resident wants to visit London
on a vacation (an import of tourist
services). She will have to pay in
pounds for her stay there. She will need
to know where to obtain the pounds
Your currency in exchange for the dollar?
Should exchange rates between two currencies
continue like this? Discuss.
2015-16(21/01/2015)
79 79 79 79 79
Open Economy
Macroeconomics
and at what price. Her demand for pounds would constitute a demand for foreign
exchange which would be supplied in the foreign exchange market – the market
in which national currencies are traded for one another. The major participants
in this market are commercial banks, foreign exchange brokers and other
authorised dealers and the monetary authorities. It is important to note that,
although the participants themselves may have their own trading centres, the
market itself is world-wide. There is close and continuous contact between the
trading centres and the participants deal in more than one market.
The price of one currency in terms of the other is known as the exchange
rate. Since there is a symmetry between the two currencies, the exchange rate
may be defined in one of the two ways. First, as the amount of domestic currency
required to buy one unit of foreign currency, i.e. a rupee-dollar exchange rate of
Rs 50 means that it costs Rs 50 to buy one dollar, and second, as the cost in
foreign currency of purchasing one unit of domestic currency. In the above case,
we would say that it costs 2 cents to buy a rupee. The practice in economic
literature, however, is to use the former definition – as the price of foreign currency
in terms of domestic currency. This is the bilateral nominal exchange rate –
bilateral in the sense that they are exchange rates for one currency against
another and they are nominal because they quote the exchange rate in money
terms, i.e. so many rupees per dollar or per pound.
However, returning to our example, if one wants to plan a trip to London,
she needs to know how expensive British goods are relative to goods at home.
The measure that captures this is the real exchange rate – the ratio of foreign
to domestic prices, measured in the same currency. It is defined as
Real exchange rate = 
f
eP
P
(6.1)
where P and P
f
  are the price levels here and abroad, respectively, and e is
the rupee price of foreign exchange (the nominal exchange rate). The numerator
expresses prices abroad measured in rupees, the denominator gives the
domestic price level measured in rupees, so the real exchange rate measures
prices abroad relative to those at home. If the real exchange rate is equal to
one, currencies are at purchasing power parity. This means that goods cost
the same in two countries when measured in the same currency. For instance,
if a pen costs $4 in the US and the nominal exchange rate is Rs 50 per US
dollar, then with a real exchange rate of 1, it should cost Rs 200 (eP
f
 = 50 × 4)
in India. If the real exchange rises above one, this means that goods abroad
have become more expensive than goods at home. The real exchange rate is
often taken as a measure of a country’s international competitiveness.
Since a country interacts with many countries, we may want to see the
movement of the domestic currency relative to all other currencies in a single
number rather than by looking at bilateral rates. That is, we would want an
index for the exchange rate against other currencies, just as we use a price
index to show how the prices of goods in general have changed. This is calculated
as the Nominal Effective Exchange Rate (NEER) which is a multilateral rate
representing the price of a representative basket of foreign currencies, each
weighted by its importance to the domestic country in international trade (the
average of export and import shares is taken as an indicator of this). The Real
Effective Exchange Rate (REER) is calculated as the weighted average of the
real exchange rates of all its trade partners, the weights being the shares of the
respective countries in its foreign trade. It is interpreted as the quantity of
domestic goods required to purchase one unit of a given basket of foreign goods.
2015-16(21/01/2015)
Page 5


Chapter 6
Open Economy Open Economy Open Economy Open Economy Open Economy
Macroeconomics Macroeconomics Macroeconomics Macroeconomics Macroeconomics
We have so far assumed that the economy was closed—that it did
not interact with the rest of the world. This was done to keep the
model simple and explain the basic macroeconomic mechanisms.
In reality, most modern economies are open. Interaction with other
economies of the world widens choice in three broad ways
(i) Consumers and firms have the opportunity to choose between
domestic and foreign goods. This is the product market linkage
which occurs through international trade.
(ii) Investors have the opportunity to choose between domestic and
foreign assets. This constitutes the financial market linkage.
(iii) Firms can choose where to locate production and workers to
choose where to work. This is the factor market linkage. Labour
market linkages have been relatively less due to various
restrictions on the movement of people through immigration
laws. Movement of goods has traditionally been seen as a
substitute for the movement of labour . We focus here on the first
two linkages.
An open economy is one that trades with other nations in
goods and services and, most often, also in financial assets. Indians,
for instance, enjoy using products produced around the world
and some of our production is exported to foreign 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
domestically produced goods. Total foreign trade (exports +
imports) as a proportion of GDP is a common measure of the degree
of openness of an economy. In 2013-14, this was 44.1 per cent
for the Indian Economy.  There are several countries whose foreign
trade proportions are above 50 per cent of GDP.
Now, when goods move across national borders, money must
move in the opposite direction. At the international level, there is no
single currency that is issued by a central authority. Foreign economic
agents will accept a national currency only if they are convinced that
the currency will maintain a stable purchasing power. Without this
confidence, a currency will not be used as an international medium
2015-16(21/01/2015)
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.
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,
over whose value the issuing authority has no control. 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 conversion takes place. The international monetary system
has been set up to handle these issues and ensure stability in international
transactions. A nation’s commitment regarding the above two issues will affect its
trade and financial interactions with the rest of the world.
We begin section 6.1 with the accounting of international trade and financial
flows. The next section examines the determination of price at which national currencies
are exchanged for each other. In section 6.3, the closed economy income-expenditure
model is amended to include international effects. Section 6.4 deals with the linkage
between the trade deficit, budget deficit and the savings - investment gap briefly.
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. Table 6.1 gives the balance of payments summary
for the Indian Economy for the year 2012-13. There are two main accounts in
the BoP – the current account and the capital account.
The current account records exports and imports in goods and services and
transfer payments. The first two items in Table 6.1 record exports and imports of
goods. The third item gives the trade balance which is obtained by subtracting
imports of goods from the exports of goods. When exports exceed imports, there is
a trade surplus and when imports exceed exports there is a trade deficit. In
2012-13, imports exceeded exports leading to a huge trade deficit in India of
US $ 195.6 billion. Trade in services denoted as invisible trade (because they are
not seen to cross national borders) includes both factor income (net income from
compensation of employees and net investment income, the latter equals, the interest,
profits and dividends on our assets abroad minus the income foreigners earn on
assets they own in India) and net non-factor income (shipping, banking, insurance,
tourism, software services, etc.). Transfer payments are receipts which the residents
of a country receive ‘for free’, without having to make any present or future payments
in return. They consist of remittances, gifts and grants. They could be official or
private. The balance of exports and imports of goods is referred to as the trade
balance. Adding trade in services and net transfers to the trade balance, we get the
current account balance shown in item 5 of Table 6.1. This figure means that
transactions from the current account component caused –88.2 billion more dollars
to flow out as payment than the receipts that flowed in. This is referred to as a
current account deficit for 2012-13 works out to 4.7 per cent of GDP. If this
figure had been a positive number, there would have been a current account
surplus. The capital account records all international purchases and sales of assets
such as money, stocks, bonds, etc. We note that any transaction resulting in a
payment to foreigners is entered as a debit and is given a negative sign. Any
transaction resulting in a receipt from foreigners is entered as a credit and is given
a positive sign.
EXAMPLE  6.1
Can a country have a trade deficit and a current account surplus simultaneously?
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Open Economy
Macroeconomics
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Introductory Macroeconomics
Yes, in India, although trade deficit is a recurrent feature every year, for three
consecutive years from 2001-02, 2002-03 to 2003-04, there was a surplus on the
current account, to the tune of 0.7, 1.3 and 2.3 per cents of GDP respectively. This
is because that earnings from services and private transfers outweighed the trade
deficit.
6.1.1 BoP 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
abroad 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 is of
necessity financed by a net capital inflow.
Alternatively, the country could engage in official reserve transactions,
running down its reserves of foreign exchange, in the case of a deficit by selling
foreign currency in the foreign exchange market. 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). The balance of
payments deficit or surplus is obtained after adding the current and capital
account balances. In 2012-13, there was a balance of payments surplus of US$
3.8 billion in item 14 of Table 6.1. This was the amount of addition to official
reserves. A country is said to be in balance of payments equilibrium when the
sum of its current account and its non-reserve capital account equals zero, so
that the current account balance is financed entirely by international lending
without reserve movements. We note that the official reserve transactions are
more relevant under a regime of pegged exchange rates than when exchange
rates are floating. (See section 6.2.3)
Autonomous and Accommodating Transactions: International economic
transactions are called autonomous when transactions are made independently
of the state of the BoP (for instance due to profit motive). 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 net consequences of the autonomous items, that is, whether
the BoP is in surplus or deficit. The official reserve transactions are seen as the
accommodating item in the BoP (all others being autonomous).
Errors and Omissions constitute the third element in the BoP (apart from
the current and capital accounts) which is the ‘balancing item’ reflecting our
inability to record all international transactions accurately.
6.2 THE FOREIGN EXCHANGE MARKET
Having considered accounting of
international transactions on the
whole, we will now take up a single
transaction. Let us assume that an
Indian resident wants to visit London
on a vacation (an import of tourist
services). She will have to pay in
pounds for her stay there. She will need
to know where to obtain the pounds
Your currency in exchange for the dollar?
Should exchange rates between two currencies
continue like this? Discuss.
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Open Economy
Macroeconomics
and at what price. Her demand for pounds would constitute a demand for foreign
exchange which would be supplied in the foreign exchange market – the market
in which national currencies are traded for one another. The major participants
in this market are commercial banks, foreign exchange brokers and other
authorised dealers and the monetary authorities. It is important to note that,
although the participants themselves may have their own trading centres, the
market itself is world-wide. There is close and continuous contact between the
trading centres and the participants deal in more than one market.
The price of one currency in terms of the other is known as the exchange
rate. Since there is a symmetry between the two currencies, the exchange rate
may be defined in one of the two ways. First, as the amount of domestic currency
required to buy one unit of foreign currency, i.e. a rupee-dollar exchange rate of
Rs 50 means that it costs Rs 50 to buy one dollar, and second, as the cost in
foreign currency of purchasing one unit of domestic currency. In the above case,
we would say that it costs 2 cents to buy a rupee. The practice in economic
literature, however, is to use the former definition – as the price of foreign currency
in terms of domestic currency. This is the bilateral nominal exchange rate –
bilateral in the sense that they are exchange rates for one currency against
another and they are nominal because they quote the exchange rate in money
terms, i.e. so many rupees per dollar or per pound.
However, returning to our example, if one wants to plan a trip to London,
she needs to know how expensive British goods are relative to goods at home.
The measure that captures this is the real exchange rate – the ratio of foreign
to domestic prices, measured in the same currency. It is defined as
Real exchange rate = 
f
eP
P
(6.1)
where P and P
f
  are the price levels here and abroad, respectively, and e is
the rupee price of foreign exchange (the nominal exchange rate). The numerator
expresses prices abroad measured in rupees, the denominator gives the
domestic price level measured in rupees, so the real exchange rate measures
prices abroad relative to those at home. If the real exchange rate is equal to
one, currencies are at purchasing power parity. This means that goods cost
the same in two countries when measured in the same currency. For instance,
if a pen costs $4 in the US and the nominal exchange rate is Rs 50 per US
dollar, then with a real exchange rate of 1, it should cost Rs 200 (eP
f
 = 50 × 4)
in India. If the real exchange rises above one, this means that goods abroad
have become more expensive than goods at home. The real exchange rate is
often taken as a measure of a country’s international competitiveness.
Since a country interacts with many countries, we may want to see the
movement of the domestic currency relative to all other currencies in a single
number rather than by looking at bilateral rates. That is, we would want an
index for the exchange rate against other currencies, just as we use a price
index to show how the prices of goods in general have changed. This is calculated
as the Nominal Effective Exchange Rate (NEER) which is a multilateral rate
representing the price of a representative basket of foreign currencies, each
weighted by its importance to the domestic country in international trade (the
average of export and import shares is taken as an indicator of this). The Real
Effective Exchange Rate (REER) is calculated as the weighted average of the
real exchange rates of all its trade partners, the weights being the shares of the
respective countries in its foreign trade. It is interpreted as the quantity of
domestic goods required to purchase one unit of a given basket of foreign goods.
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Introductory Macroeconomics
6.2.1 Determination of the Exchange Rate
The question arises as to why the foreign exchange rate
1
 is at this level and what
causes its movements? To understand the economic principles that lie behind
exchange rate determination, we study the major exchange rate regimes
2
 that
have characterised the international monetary system. There has been a move
from a regime of commitment of fixed-price convertibility to one without
commitments where residents enjoy greater freedom to convert domestic currency
into foreign currencies but do not enjoy a price guarantee.
6.2.2 Flexible Exchange Rates
In a system of flexible exchange rates (also known as floating exchange
rates), the exchange rate is determined by the forces of market demand and
supply. In a completely flexible system, the central banks follow a simple set of
rules – they do nothing to directly affect the level of the exchange rate, in other
words they do not intervene in the foreign exchange market (and therefore, there
are no official reserve transactions). The link between the balance of payments
accounts and the transactions in the foreign exchange market is evident when
we recognise that all expenditures by domestic residents on foreign goods,
services and assets and all foreign transfer payments (debits in the BoP accounts)
also represent demand for foreign exchange. The Indian resident buying a
Japanese car pays for it in rupees but the Japanese exporter will expect to be
paid in yen. So rupees must be exchanged for yen in the foreign exchange market.
Conversely, all exports by domestic residents reflect equal earnings of foreign
exchange. For instance, Indian exporters will expect to be paid in rupees and, to
buy our goods, foreigners must sell their currency and buy rupees. Total credits
in the BoP accounts are then equal to the supply of foreign exchange. Another
reason for the demand for foreign exchange is for speculative purposes.
Let us assume, for simplicity, that India and the United States are the only
countries in the world, so that there is only one exchange rate to be determined.
The demand curve (DD) is downward sloping because a rise in the price of foreign
exchange will increase the cost in terms of rupees of purchasing foreign goods.
Imports will therefore decline and less foreign exchange will be demanded. For
the supply of foreign exchange to increase as the exchange rate rises, the foreign
demand for our exports must be
more than unit elastic, meaning
simply that a one per cent increase
in the exchange rate (which
results in a one per cent decline
in the price of the export good to
the foreign country buying our
good) must result in an increase
in demand of more than one per
cent. If this condition is met, the
rupee volume of our exports will
rise more than proportionately to
the rise in the exchange rate, and
earnings in dollars (the supply of
foreign exchange) will increase as Equilibrium under Flexible Exchange Rates
1
Between any two currencies
2
An exchange rate regime or system is a set of international rules governing the setting of
exchange rates.
2015-16(21/01/2015)
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