Chapter 6. Open Economy Macroeconomics

• An open economy is one that interacts with other countries through various channels.
Output Market: An economy can trade in goods and services with other countries. This widens choice in sense that consumers and producers can choose between domestic and foreign goods.
Labour Market: Firms can choose where to locate production and workers can choose where to work. There are various immigration laws which restrict movement of labour between countries.
Financial Market: Most often an economy can buy financial assets from other countries. This gives investors opportunity to choose between domestic and foreign assets.
• Foreign trade influences Indian aggregate demand in two ways:
(1) First, when Indians buy foreign goods, this spending escapes as a leakage from circular flow of income decreasing aggregate demand.
(2) Second, our exports to foreigners enter as an injection into circular flow, increasing aggregate demand for goods produced within domestic economy.
• international monetary system has been set up to handle these issues and ensure stability in international transactions.
• Foreign exchange rate refers to rate at which one currency is exchanged for other.

Balance of Payments [BOP]
• It records transactions in goods, services, & assets between residents of a country and rest of world for a specified time period, typically a year.
• Economic transactions refer to those transactions which involve transfer of ownerships or little of goods, services, money, & assets.

BOP Deficit Balanced BOP BOP Surplus
Overall Balance < 0 Overall Balance = 0 Overall Balance > 0
Reserve Change > 0 Reserve Change = 0 Reserve Change < 0

Current Account
• This is record of trade in goods and services and unilateral transfer payments during a given period of time.
• current account contains receipts and payments relating to all transaction of visible items, invisible items and unilateral transfers.

Balance on Current Account
• Current Account is in balance when receipts on current account are equal to payments on current account.

Current Account Surplus Balanced Current Account Current Account Deficit
Receipts > Payments Receipts = Payments Receipts < Payments

Trade in goods: It includes exports and imports of goods.
Trade in services: It includes factor income and nonfactor income transactions.
Unilateral transfer payments: They are receipts which residents of a country get for ‘free’, without having to provide any goods or services in return.
(1) They consists of gifts, remittances and grants.
(2) They could be given by government or by private citizens living abroad.

Balance of Trade [BOT]
• This is difference between value of exports and value of imports of goods by a country in a given period of time. This is called Trade Balance.
• BOT is said to be in balance when exports of goods are equal to imports of goods.

Net Invisibles
• This is difference between value of exports and value 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
Services trade includes both factor and non-factor income:
(1) Factor income includes net international earnings on factors of production [like labour, land & capital].
(2) Non-factor income is net sale of service products like shipping, banking, tourism, software services.

Capital Account
• Capital Account records all international transactions of assets in other words it deals with foreign exchange reserves, investments, loans & borrowings.
(1) An asset is any one of forms in which wealth can be held, for example: money, stocks, bonds, government debt.

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].
• reserve bank sells foreign exchange when there is a deficit. It is known as official reserve sale. decrease [increase] in official reserves is known as overall balance of payments deficit [surplus].
• Buying foreign goods is an expenditure from a country and it becomes income of that foreign country. Hence, purchase of foreign goods or imports decreases domestic demand for goods and services in our country.
• Selling of foreign goods or exports brings income to our country and adds to aggregate domestic demand for goods and services in our country.

Autonomous and Accommodating Transactions
• transactions recorded in balance of payment accounts can be categorized as Autonomous Transactions and Accommodating transactions.
• International economic transactions are known as autonomous when transactions are made due to some reason other than to bridge gap in balance of payments, that is, when they are independent of state of BOP.
• Accommodating transactions are determined by gap in balance of payments, that is, whether there is a deficit or surplus in balance of payments.

Errors and Omissions
• This is difficult to record all international transactions accurately. Thus, third element of BOP, [apart from current and capital accounts] known as errors and omissions, reflects this.

Foreign Exchange Market
• market in which national currencies are traded for one another.
• major participants in foreign exchange market are commercial banks, foreign exchange brokers, and other authorised dealers and monetary authorities.

Foreign Exchange Rate
• price of one currency in terms of another currency is called foreign exchange rate or simply exchange rate. This is known as Forex Rate. This is price of one currency in terms of another. It links currencies of different countries and enables comparison of international costs and prices.
• A rise in price of foreign exchange will reduce foreigner’s cost while purchasing products from India, other things remaining constant. This increases India’s exports and hence, supply of foreign exchange may increase.

Demand for Foreign Exchange Reason:
• They want to purchase goods and services from other countries; They want to send gifts abroad; and They want to purchase financial assets of certain country.

Supply of Foreign Exchange
• Foreign currency flows into home country due to following reasons:
(1) Exports by a country lead to purchase of its domestic goods and services by foreigners;
(2) Foreigners send gifts or make transfers; and
(3) assets of a home country are bought by foreigners.

Import Terminologies
• Increase in exchange rate implies that price of foreign currency in terms of domestic currency has increased. It is known as Depreciation of domestic currency in terms of foreign currency.
• When price of domestic currency in terms of foreign currency increases, it is known as an appreciation of domestic currency in terms of foreign currency.
• A rise in interest rates at home often leads to an appreciation of domestic currency.

Factor determining Exchange Rate
• In short run, another factor that is important in determining exchange rate movements is interest rate differential i.e., difference between interest rates in different countries.

Demand & Supply Curve for Exchange Rate
• When income increases, consumer spending increases. Spending on imported goods is likely to increase. When imports increase, demand curve for foreign exchange shifts to right. There is a depreciation of domestic currency. If there is an increase in income abroad as well, domestic exports will rise and supply curve of foreign exchange shifts outward.

Purchasing Power Parity
• purchasing Power [PPP] theory is used to make long-run predictions about exchange rates in a flexible exchange rate system.

Types of Exchange Rate
• It can be determined through Flexible Exchange Rate, Fixed Exchange Rate or Managed Floating Exchange Rate.

Fixed Exchange Rate:
• In this exchange rate system, government fixes exchange rate at a particular level.
• In a fixed exchange rate system, when some government action increases exchange rate it is known as a Devaluation. Thereby, making domestic currency cheaper.
• Revaluation is said to occur when government decreases exchange rate in a fixed exchange rate system. Thereby, making domestic currency costlier.

Flexible Exchange Rate:
• This exchange rate is determined by market forces of demand and supply. This is called Floating Exchange Rate.
• In a completely flexible system, central banks do not intervene in foreign exchange market.

Managed floating exchange rate system:
• This is a mixture of a flexible exchange rate system [the float part] and a fixed rate system [the managed part].
• Under this system, known as dirty floating, central banks intervene to buy and sell foreign currencies in an attempt to moderate exchange rate movements whenever they feel that such actions are appropriate.

Merits and Demerits of Flexible and Fixed Exchange Rate Systems
• main feature of fixed exchange rate system is that there must be credibility that government will be able to maintain exchange rate at level specified. Often, if there is a deficit in BOP in a fixed exchange rate system, governments will have to intervene to take care of gap by use of its official reserves.
• flexible exchange rate system gives government more flexibility, and they do not need to maintain large stocks of foreign exchange reserves.
• major advantage of flexible exchange rates is that movements in exchange rate automatically take care of surpluses and deficits in BOP.
• Also, countries gain independence in conducting their monetary policies since they do not have to intervene to maintain exchange rates, which are automatically taken care of by market.

Gold Standard
• From around 1870 to outbreak of First World War in 1914, prevailing system was gold standard, which was epitome of fixed exchange rate system. All currencies were defined in terms of gold.
• To maintain official parity each country needed an adequate stock of gold reserves. All countries on gold standard had stable exchange rates.
David Hume, a noted philosopher writing in 1752, refuted this view and pointed out that if stock of gold went down, all prices and costs would fall commensurately and no one in country would be worse off

Bretton Woods System
• Bretton Woods Conference, held in 1944, set up International Monetary Fund [IMF] and World Bank and re-established a system of fixed exchange rates.
• It was different from international gold standard in choice of asset in which national currencies would be convertible.
• A two-tier system of convertibility was established, at centre of which was dollar.
• Triffin suggested that IMF should be turned into a ‘deposit bank’ for central banks and a new ‘reserve asset’ be created under control of IMF.

Special Drawing Rights of International Monetary Fund
• In 1967, gold was displaced by creating Special Drawing Rights [SDRs], called ‘paper gold’, in IMF with intention of increasing stock of international reserves. It has been redefined several times since 1974. At present, it is calculated daily as weighted sum of values in dollars of five currencies [euro, dollar, Japanese yen, pound, sterling & renminbi [included in 2016]] of five countries [France, Germany, Japan, UK, China & US].

Global Scenario of adopting Exchange Rate
• developed market economies, led by United Kingdom and soon followed by Switzerland and then Japan, began to adopt floating exchange rates in early 1970s.
• In 1976, a revision of IMF Articles allowed countries to choose whether to float their currencies or to peg them [to a single currency, a basket of currencies, or to SDR].
• There are no rules governing pegged rates and no defacto supervision of floating exchange rates.

Current Scenario
• Many countries currently have fixed exchange rates. creation of European Monetary Union in January, 1999, involved permanently fixing exchange rates between currencies of members of Union and introduction of a new common currency, Euro, under management of European Central Bank.
• From January, 2002, actual notes and coins were introduced. So far, 19 of 25 members of European Union have adopted euro.
• Another arrangement adopted by Ecuador in 2000 was dollarisation when it abandoned domestic currency and adopted US dollar.

Exchange Rate Management: Indian Experience
• India’s exchange rate policy has evolved in line with international and domestic developments.
• Reserve Bank intervened on a day-to-day basis which resulted in wide changes in size of reserves.
• beginning of 1990s saw a significant rise in oil prices and suspension of remittances from Gulf region in wake of Gulf crisis.
• This, and other domestic and international developments, led to severe balance of payments problems in India.
• drying up of access to commercial banks and short-term credit made financing current account deficit difficult. India’s foreign currency reserves fell rapidly.
• Apart from measures like sending gold abroad, curtailing non-essential imports, approaching IMF and multilateral and bilateral sources, introducing stabilisation and structural reforms, there was a twostep devaluation of 18 –19% of rupee on July 1 and 3, 1991.

Liberalised Exchange Rate Management System [LERMS]
• In March 1992, LERMS involving dual exchange rates were introduced.
• Under this system, 40% of exchange earnings had to be surrendered at an official rate determined by Reserve Bank and 60% was to be converted at market determined rates.
• dual rates were converted into one on March 1, 1993; this was an important step towards current account convertibility.

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